American Bar Association
32nd Annual Forum on Franchising
Sourcing Products And Services For The System:
Efficiencies And Traps In Supply Chain Management
Chesley K. Bud Culp III
Moye White LLP
and
Rochelle B. Spandorf
Davis Wright Tremaine LLP
October 14 - 16, 2009
The Westin Harbour Castle
Toronto, Canada
©2009 American Bar Association
TABLE OF CONTENTS
Page
I.
INTRODUCTION ...............................................................................................................1
II.
THE FRANCHISE SUPPLY CHAIN ..................................................................................2
III.
THE LEGAL FRAMEWORK GOVERNING THE FRANCHISE SUPPLY CHAIN..............7
IV.
BENEFITS ARISING FROM FRANCHISOR CONTROL OVER AND
INVOLVEMENT IN THE SOURCE OF PRODUCTS AND SERVICES...........................22
V.
TENSIONS ARISING FROM FRANCHISOR CONTROL OVER AND
INVOLVEMENT IN THE SOURCE OF PRODUCTS AND SERVICES...........................25
VI.
DISCLOSING AND ADDRESSING SOURCING RESTRICTIONS IN THE
FRANCHISE AGREEMENT: BEST PRACTICES ..........................................................30
VII.
PROCUREMENT AND VENDOR AGREEMENTS: BEST PRACTICES ........................34
VIII.
CONCLUSION.................................................................................................................41
i
SOURCING PRODUCTS AND SERVICES FOR THE SYSTEM:
EFFICIENCIES AND TRAPS IN SUPPLY CHAIN MANAGEMENT
I.
INTRODUCTION
It has been observed that [t]he strength of franchise systems typically does not lie in the
absolute quality of the products offered . . . [but] in the capacity of the franchised chain to offer a
uniform product at a reasonable price. 1 Customers know what to expect when they patronize
an outlet in a franchised chain, and it is important for the chains to successfully meet these
expectations time after time. 2 Product uniformity also brings operational advantages, allowing
the franchisor to use all of the buying power of the chain in order to increase opportunities for
economies of scale in procurement and distribution.3
To address the need for product uniformity and to allow the franchise system to take
advantage of the buying power of the chain, many franchisors seek to strictly control the source
of products and/or services used or obtained by their franchisees, often by designating
approved products, services, suppliers, or organizing supply chain functions through
outsourcing or direct management. Some franchisors use precise contractual language within
the franchise agreement regarding the products and services its franchisees can use.4 Others
may seek to assure uniform product quality by imposing a requirement that franchisees buy
supplies only from the franchisor.5 However these arrangements are structured, franchisor input
purchase requirements are a means of preserving the level and uniformity of quality of the
products sold to the customer.6
While such restrictions are common, they do not remove certain individual franchisee s
economic incentive to reduce or modify product quality for their private gain. They merely police
the problem. As a result, such restrictions typically must be monitored through audits and
mystery shopper programs with sanctions levied for noncompliance.7 The franchisor s control
over the source of products and services may also come under attack by franchisees who
complain about the price at which the products and services are offered. This can be
particularly true when, as is often the case, the franchisor, as part of the overall return on its
investment in the brand, receives remuneration from sourcing products to the system. In some
1
ROGER D. BLAIR & FRANCINE LAFONTAINE, THE ECONOMICS OF FRANCHISING 117 (2005).
2
Id.
3
Patrick J. Kaufmann & Sevgin Eroglu, Standardization and Adaption in Business Format Franchising, 14 J.
BUS. VENTURING 69-64 (1998).
4
For example, a McDonald s franchisee may serve only those food and beverage products now or
hereafter designated by McDonald s using food and beverage ingredients that meet McDonald s specifications.
2006 Franchise Agreement, McDonald s USA, LLC ¶¶ 12(a), 12(i).
5
See, e.g., Krehl v. Baskin-Robbins Ice Cream Co., 664 F.2d 1348 (9th Cir. 1982) (holding that the
franchisor could impose a requirement that its franchisees buy all of their ice cream from Baskin-Robbins).
6
See Roger D. Blair & David L. Kaserman, A Note on Incentive Incompatibility Under Franchising, 9 REV.
INDUS. ORG. 323 (1994).
7
BLAIR & LAFONTAINE, supra note 1, at 128.
1
instances, franchisees may organize their own buying group to achieve volume discounts for
themselves or seek to substitute their group as the purchasing agent for the entire system.
This paper provides an general overview of the franchise supply chain, the benefits
provided by franchisor involvement in and control over the sourcing of products and services,
and the tensions that may arise as a result. Readers will also learn the best practices in
procurement and structuring franchise supply arrangements, and how to address these
arrangements in the franchise agreement.
II.
THE FRANCHISE SUPPLY CHAIN
A.
Overview
A supply chain consists of all stages involved, directly or indirectly, in fulfilling a
customer request. 8 In its simplest form, it is composed of a company and the suppliers and
customers of that company. When its constituent parts are broken down further, a supply chain
not only includes the manufacturer and suppliers, but also transporters, warehouses, retailers
and customers themselves . . . 9
Supply chain management is the coordination of production, inventory, location, and
transportation among the participants in a supply chain to achieve the best mix of
responsiveness and efficiency for the market being served. 10
Effective supply chain
management tends to focus on five aspects or drivers.11 The first driver is production: what
products does the market want, how much, and by what date. The second is inventory.
Inventory serves as a buffer against uncertainty in the supply chain; however, holding inventory
is expensive, so it must be held at optimal levels. The third driver is location. A company must
determine the most cost efficient location for both production and inventory storage. The fourth
driver is transportation. A company must determine how the inventory should most efficiently be
moved from one supply chain location to the next. The final driver is information. Daily
information between each participant in the supply chain is necessary for it to function.
Information is also needed to forecast the company s future product, transportation and
distribution needs.
Each organization attempts to maximize its supply chain management performance
through a combination of outsourcing, partnering, and in-house experience. Today, in the fastmoving global markets of the modern economy, most companies tend to focus on their core
competencies in supply chain management and outsource the rest. Franchisors are no
different.
8
SUNIL CHOPRA & PETER MEINDL, SUPPLY CHAIN (2d ed. 2003).
9
Id.
10
MICHAEL HUGOS, ESSENTIALS OF SUPPLY CHAIN MANAGEMENT 4 (2d ed. 2006).
11
Id. at 5-6 (discussing the five drivers).
2
B.
Elements of the Supply Chain
1.
Producers (Manufacturer or Vendor)
At the beginning of the supply chain are the producers. These are the manufacturers or
vendors that make the product or provide the service. This includes companies that are
producers of raw materials and companies that are producers of finished goods. 12 A producer
can also provide an intangible product such as music, software or designs, or a producer can
provide services, such as landscape maintenance or office cleaning. Increasingly, the
producers of tangible, industrial products are moving to areas of the world in which labor is less
costly, while producers of intangible items or services are located in North America, Europe and
parts of Asia.
2.
Logistics Provider (Inbound Freight)
The next link in the franchise supply chain are the logistics providers. These are the
transportation companies that deliver the product inbound from the manufacturer to the next
participant in the supply chain, often a regional distribution center. Traditionally, there were four
modes of transport from which a logistics provider could chose: (1) shipping, which is very cost
efficient moving product overseas transport, but is also the slowest mode of transport; (2) rail,
which is also very cost efficient, but is restricted to use between locations served by rail lines;
(3) trucks, which are a relatively quick and flexible mode of transport, but prone to price
fluctuations with the cost of fuel; and (4) air, which is very fast and very responsive, but is the
most expensive mode of transport. Additionally, today increasingly a fifth mode of transport,
electronic, is being used by all manner of producers of intangible goods.
The job of the supply chain manager is to design routes and networks to move the
products in accordance with the needs of the system. As a general rule, the higher the value of
the product (such as electronic components or pharmaceuticals), the more the transportation
network should emphasize responsiveness; the lower the value of a product (such as bulk
commodities and staples with a long shelf life), the more the network should emphasize
efficiency.13
3.
Distributor (Outbound Freight)
Distributors take inventory in bulk from producers and deliver a bundle of related
products to customers. Product is shipped from the supplier to the distribution center or
warehouse. In the case of single source distributing, the products received from the
manufacturer are then combined with all of the products required by the franchisee. The
franchisee can then order from the distributor from a single order guide, and the products are
delivered by the distributor to the franchisee on the most efficient basis, typically one to two
deliveries a week.
Distributors can either take ownership of the inventory or simply broker the product
between the producer and the franchisee without taking ownership. In either case, as the needs
of the franchise system evolve and the range of available products changes, the distributor
12
Id. at 24.
13
Id. at 15.
3
tracks those needs and matches them with the products available.14 The distributor may also
help to buffer producers from fluctuations in product demand by stocking inventory and
performing inventory management.15
4.
Retailer (Franchisee)
Retailers stock inventory and sell in smaller quantities to the general public. In the
franchise context, the retailer is the franchisee. The retailer uses some combination of price,
product selection, service and convenience in order to attract customers. Quick service
restaurants, for example, typically rely upon low price and convenience as their primary draw.
The retailer tracks the preferences and demands of the customers. In the franchising context,
this information is then relayed to the franchisor, so that it can make and modify its purchasing
decisions from manufacturers according to local customer preferences, starting the franchise
supply chain anew.
5.
Customer
The final link in the supply chain is the customer. A customer may purchase a product in
order to incorporate it into another product that they, in turn, sell to another customer. However,
in the franchising context, a customer is typically the final user of the product who purchases the
product in order to consume it.
C.
Level of Franchise System Participation in the Supply Chain
1.
Minimal Involvement: Broadline Distribution
When a franchise system begins, it generally outsources all aspects of supply chain
management to a large broadline distributor with a large catalogue of merchandize available to
supply the system. Broadliners are involved in, and make money from, virtually all aspects of
the supply chain. They negotiate purchases from manufacturers. They contract with logistics
providers to transport the product and aggregate the orders of multiple individual customers and
franchise systems in order to secure for network members the lowest prices available.
Broadliners store the product in centralized distribution centers, often times which they own.
They also distribute products to the retailers, i.e. the franchisees, again in trucks which they
own. Examples of broadliners in the food supply chain include Sysco and US Foods.
Franchise systems pay for the broadliner s wide-ranging inventory and supply chain
management expertise. The franchise system benefits because it is not required to develop the
expertise of supply chain management in-house. Nor does the system have to make the
financial outlay to pay for the inventory needed by the franchise system or take responsibility for
inventory shortages, unsold inventory or returns.
At the same time, because the broadliner purchases for many customers, it is generally
unable to develop or supply specialized or proprietary products to the franchise system. If the
franchise system needs roasted turkey breast, that is what the broadliner provides, and the
quality the franchisee receives will vary depending on the underlying supplier and geographic
region where procurement occurs. Conversely, competing purchasers who are located with the
14
Id. at 25.
15
Id. at 24-25.
4
same geographic region and purchase from the same broadliner will often receive identical
products, viz., the product the broadliner has available at that time in that distribution center,
limiting the ability of competing retailers within the geographic region to differentiate themselves
from one another to consumers.
Consequently, when a franchisor outsources its supply chain management to a
broadline distributor, only those products deemed critical to the brand will be restricted to a
specific vendor or supplier, and only then if the franchise system has enough purchasing power
to require the broadliner to make purchases from a single or group of manufacturers producing
products according to the franchisor s specifications. Otherwise, the franchisor will provide for
all of its supply needs by purchasing off the rack from a menu of available broadline stock.
2.
Intermediate Involvement: Cost Plus Distribution
As franchise systems evolve, they typically develop confidential specifications for more
of the products offered to the customer. Confidential specifications are developed to ensure
that high and uniform quality is maintained, thus promoting the image and reputation of the
product offered by the franchise system as compared to its competitors. Confidential
specifications also enable a franchise system to differentiate itself from its competitors. With
increasingly proprietary product specifications, the franchisor s need to control the source of
products and services used or obtained by its franchisees increases as well. As the franchisor
develops exclusive relationships with vendors manufacturing products to its specification, the
number of approved sources for products becomes more restricted.
In order to meet this need, a franchisor may partner exclusively with a system-wide
dedicated logistics and supply chain manager, e.g., Perseco (McDonald s) or it may bring some
or all of the tasks previously outsourced to broadline distributors in-house. For example, the
franchisor (or its exclusive supply chain partner) may begin to negotiate directly with vendors
and manufacturers, relying on the increasing size and purchasing power of the franchise system
to supplant the need for the aggregate purchasing power formerly supplied by the broadline
distributor. Direct negotiation with vendors often leads to better logistics management, as the
franchisor can select vendors that are conveniently located to its retail outlets, thereby allowing
the franchisor to reduce the costs of inbound freight to the distribution center. Finally, the
franchisor may negotiate directly with distributors, choosing warehouse locations that are
centrally located within a radius of franchised outlets. The resulting cost savings of this strategy
has been amply demonstrated by Walmart, which implemented a strategy of first building its
distribution facilities in a central area within a geographic market that could support several
regional outlets, and then building its retail stores around the distribution center.16
This intermediate level of involvement in supply chain management is sometimes
referred to as cost plus distribution. In other words, the franchisor negotiates with the various
participants in the supply chain, obtains a price from the manufacturer, logistics provider or
distributor based on that participant s cost, then adds a margin to cover the expense of this
service incurred by the franchisor. By contracting in this manner, either in-house or with the
assistance of a system-dedicated supply chain partner, a franchisor can potentially substantially
reduce the mark up which are profits of the individual supply chain participants, but are costs to
the franchisor and its franchisees. As discussed below, in addition to the potential savings
reaped from the supply chain, bringing aspects of supply chain management in-house may also
16
Id. at 19.
5
allow the franchise system to realize a host of additional benefits, including greater quality
control, increased safety and brand protection, price stabilization, and more rapid response to
franchisee problems with the supply chain and the changing needs of the system.
3.
Heavy Involvement: Ownership of Manufacturer/Distributor
In the slower moving mass markets of the industrial age it was common for successful
companies to attempt to own much of their supply chain. 17 This is known as vertical
integration. The aim of vertical integration was to gain maximum efficiency through economies
of scale. 18 For example, in the first half of the 1900s, Ford Motor Company owned virtually its
entire supply chain.19 It owned and operated mines that extracted iron ore. It owned the steel
mills and plants that fabricated components. It even owned farms where it grew flax to make
into linen car tops. It was a profitable way to do business, but it also led to a one size fits all
product. Famously, when Henry Ford was asked about the number of different car colors a
customer could request, he reputedly said, they can have any color they want as long as it s
black.
Today, companies rarely seek to vertically integrate the entire supply chain. Instead,
companies focus on the activities they do best. Where companies once routinely ran their own
warehouses or operated their own fleet of trucks, they now have to consider whether those
operations are really a core competency or whether it is more cost effective to outsource those
operations to other companies that make logistics the center of their business. 20 Instead of
vertical integration, companies now practice virtual integration, partnering with others for
various aspects of the supply chain.
The level of franchise system ownership of the supply chain is largely driven by the
format of franchising employed, traditional (or product or trade name franchising) or businessformat franchising.
Traditional franchising is characterized by franchised dealers who
concentrate on one product line and identify their business with that company, such as
automobile dealerships, gasoline stations and soft-drink bottlers; whereas, business-format
franchising sells a way of doing business, including the product, trademark, marketing strategy
and operating manual, such as most restaurant franchises.21
Unlike Henry Ford, traditional franchisors today generally do not aspire to own the entire
supply chain. However, they do typically own the facilities that manufacture and sell finished or
semi-finished products to its dealers/franchisees. In contrast, in the case of business-format
franchising, most franchisors do not have the option of selling a finished product to its
franchisees because production takes place downstream, e.g., the customer s meals are
produced at the franchisee s restaurant, not at the franchisor s head office. However, some
business-format franchisors do own some aspect of the supply chain. For example, according
to its 2006 Prospectus, the Canadian Quick Service Restaurant ( QSR ) icon, Tim Horton s,
17
Id. at 20.
18
Id.
19
Id. at 22 (providing the information supporting the text s discussion regarding Ford).
20
Id. at 23.
21
BLAIR & LAFONTAINE, supra note 1, at 6.
6
owns 50% of the bakery that makes essentially all of the baked goods sold by its franchisees.
Tim Horton s also owns its regional distribution centers and its own fleet of trucks to deliver
baked goods inbound to the distribution centers, and deliver its suite of food and paper products
to its franchisees.
III.
THE LEGAL FRAMEWORK GOVERNING THE FRANCHISE SUPPLY CHAIN
A.
Franchise Regulatory Issues
1.
Federal and State Disclosure Obligations
a)
The Scope of Item 8
When the Federal Trade Commission ( FTC ) overhauled the original Franchise Rule
effective July 1, 2008, it chose to adopt the UFOC Guidelines' treatment of sourcing-related
issues contained in UFOC Item 8, with one significant deviation. The Amended Rule expanded
Item 8 beyond the Guidelines by requiring a franchisor to identify any supplier in which an officer
of the franchisor has more than a de minimis interest.22 For franchisors who offered and sold
franchises before July 1, 2008, the Amended Rule did not fundamentally alter their past
disclosure practices or policies applicable to supply chain issues and sourcing relationships.
The tensions between franchising parties created by sourcing restrictions were well
exposed during the FTC s 12-year rule-making process leading up to the Amended Rule s
enactment. To franchisee advocates, the duty to purchase goods or services from a particular
designated source threatens the franchisee s independence and profitability.
Sourcing
restrictions epitomize the inherent conflict between the franchisor s professed desire to see
franchisees maximize unit level profits and the franchisor s opportunity to extract additional
revenue from the franchise relationship by selecting suppliers only if they agree to kick back
revenue or other benefits as the quid pro quo for giving the suppliers access to a captive
franchise network. Particularly infuriating to franchisee advocates was the lack of regulation
over the franchisor s right to impose sourcing restrictions on purchases of purely fungible goods
without having to guarantee that chosen suppliers would extend competitive pricing or other
benefits to franchisees. Franchisee advocates urged the FTC to declare it an unfair trade
practice for franchisors to forbid a franchisee from obtaining non-proprietary supplies on more
22
The FTC s 2007 Compliance Guides expound on the new features of the Amended Franchise Rule. With
respect to the new disclosure about officers who own an interest in any supplier, the Compliance Guides instruct that
an interest" should be read broadly to mean any percentage of direct ownership from which the officer derives
income or other financial benefits regardless of how small. After releasing the 2007 Compliance Guides, the FTC
issued FAQ 18 to clarify that an interest means any interest significant enough to be material to a prospective
franchisee s investment decision. Rather than excuse disclosure when an officer s ownership interest in a supplier is
less than a specific threshold level, the FTC advises franchisors to err on the side of disclosure in assessing
materiality in each instance. The objective of the new disclosure is to expose information that might reflect a conflict
of interest in the franchisor s approval or choice of particular suppliers. The FAQ clarifies that new Item 8 does not
require franchisors either to identify the officer who owns the interest or the extent of the officer s interest. However,
new Item 8 does require the franchisor to disclose the identity of the supplier in which the unnamed officer owns an
undisclosed interest. Ironically, when it comes to other Item 8 disclosures about optional and mandatory suppliers,
the disclosure rules do not require franchisors to identify the suppliers by name. For example, franchisors do not
have to name the particular suppliers from whom they or their affiliates directly or indirectly receive revenue on
account of franchisee purchases.
Federal Trade Commission, Amended Franchise Rule FAQ s,
http://www.ftc.gov/bcp/franchise/amended-rule-faqs.shtm (last visited July 29, 2009).
7
favorable terms from alternative sources who offered more competitive pricing than the
franchisor s designated suppliers.23
By the end of the 12-year rule making process leading up to the Amended Rule, the
FTC, while certainly sympathetic to franchisee concerns, stuck with its approach of addressing
any unfairness in sourcing restrictions by mandating robust pre-sale disclosures. To the FTC,
the UFOC Guidelines Item 8 disclosures were significantly more expansive than the Original
FTC Rule, so adopting the UFOC Guidelines approach to Item 8 seemed adequate enough
reform:
Item 8 strikes the right balance between pre-sale disclosure and
compliance costs and burdens. It is sufficient to warn prospective
franchisees about source restrictions, purchase obligations, and approval
of alternative suppliers, without requiring franchisors to disclose their past
practices regarding approving alternative suppliers (which may be
irrelevant to their current practices) or their future intentions (which may
be proprietary information or misleading if the franchisor abandons the
intended direction). 24
By all accounts, with the exception of also adding the new disclosure about officer
ownership of a supplier, the states did not alter the scope of Item 8 beyond what the North
American Securities Administrators Association (NASAA) has required since 1993. When
NASAA adopted its Amended and Restated Guidelines in 2008, a year after the federal
Amended Franchise Rule took effect, NASAA purportedly adopted the Amended Rule s Item 8
disclosures and underlying policies in toto.25 Indeed, Item 8 in the Amended Rule and NASAA s
2008 Guidelines read identically.
Interestingly, however, in the FTC s 2007 Compliance Guides, the FTC explains that the
Amended Rule s Item 8 covers only those restrictions that compel a franchisee to purchase
supplies from a specific supplier or limited group of suppliers. This interpretation seems
considerably narrower than the Amended Rule itself which uses the disjunctive or in directing
franchisors also to disclose restrictions that confine a franchisee s selection of supplies to those
conforming to the franchisor s specifications even when franchisees are free to purchase
specified items from any source of their own choosing.26
NASAA, too, in its Commentary to the 2008 Guidelines, explains the intended scope of
its Item 8 more narrowly than the express language in the 2008 Guidelines would otherwise
23
Bus. Franchise Guide (CCH) ¶ 6062, Statement of Basis and Purpose (SBP) discussion of Item 8 and
note 451 (2007), available at http://www.ftc.gov/os/2007/01/R511003FranchiseRuleFRNotice.pdf.
24
Id.
25
See Bus. Franchise Guide (CCH) ¶ 5705, North American Securities Administrators Association (NASAA)
2008
Franchise
Registration
and
Disclosure
Guidelines,
available
at
http://www.nasaa.org/content/Files/2008UFOC.pdf.
26
Compare the 2007 FTC Commentary ( Item 8 covers only required purchases and leases of goods and
services that are source-restricted, meaning that the franchisee must make the purchases from a specific supplier or
limited group of suppliers. ) (emphasis added) with the 2008 NASAA Commentary ( Disclose the franchisee's
obligations to purchase or lease goods, services,
either from the franchisor, its designee, or suppliers approved by
the franchisor, or under the franchisor's specifications. ) (emphasis added).
8
suggest. Item 8 requires disclosure of all restrictions on the freedom of the franchisee to obtain
goods, real estate, services, etc. from sources of the franchisee's choosing, and of all means by
which a franchisor may derive revenue as a result of franchisee purchases or leases of goods
and services. 27 This interpretation also seems to ignore the disjunctive or phrase in the 2008
Guidelines that directs franchisors to disclose restrictions that confine a franchisee s choice of
supplies to those conforming to the franchisor s specifications regardless of whether the
franchisor restricts the franchisee s choice of supplier or derives any revenue from franchisee
transactions.
If one looks strictly at the FTC s and NASAA s explanations of their own Item 8, a
franchisor, for example, would not have to disclose that a franchisee must use Quicken Deluxe
financial accounting software if (i) the franchisee may buy the software from anyone in the
universe of suppliers selling it, and (ii) the franchisor derives no revenue on account of the
franchisee s transaction. However, under the express language in the Amended Rule and the
2008 Guidelines, the franchisor would have to identify Quicken software as a sourcing
restriction since the franchisor specifies a particular brand of financial accounting software that
the franchisee must use.
The main relevance of this distinction between the FTC s and NASAA s commentary, on
the one hand, and the express language of new Item 8, on the other, concerns three other Item
8 disclosures. These pertain to the duty to make disclosures about required purchases and
leases. Item 8 requires a franchisor to disclose (i) the franchisor s revenue from all required
purchases and leases of products and services; (ii) the percentage of a franchisor s total
revenues that are from required purchases or leases; and (iii) the estimated proportion that
required purchases and leases bear to a franchisee s overall costs to establish and operate the
franchised business. The threshold question is whether a franchisor must count as required
those supplies that a franchisee must use that conform to the franchisor s specifications when
the franchisee may purchase or lease the supplies from any source of its own choosing without
having to obtain prior written approval of the supplier and when the franchisor derives no
revenue from the transaction. If despite the language in the Amended Rule and 2008
Guidelines, a purchase or lease is required only if the franchisor must approve the supplier or
directly or indirectly derives revenue from a franchisee s transactions with a particular supplier,
then the duty to use Quicken Deluxe brand financial accounting software would not count as
required if the franchisee is free to purchase it from Best Buy, Amazon or any of the dozens of
other retailers that sell it. If one goes by the precise language in the Amended Rule and 2008
Guidelines, however, Quicken software would count as required even absent restrictions on the
franchisee s choice of supplier or revenue stream. The differences in the two interpretations
could lead to materially different disclosures about the magnitude of a franchisor s sourcing
restrictions.
No one has yet asked the FTC to clarify what it meant by the qualifying phrase covers
only in the 2007 Compliance Guides, or asked NASAA to explain if its focus on revenue
generation is meant to narrow the actual language in Item 8.28 The point discussed in this
27
Bus. Franchise Guide (CCH) ¶ 5706.
28
The scope of Item 8 has been a source of confusion for state examiners, franchisors and franchise
attorneys since NASAA revised it in 1993. In 1999, NASAA issued commentary to clarify the scope of Item 8
although those particular clarifications do not touch on the precise issue raised in the text of this paper, i.e., whether a
franchisor must identify as a sourcing restriction the duty to purchase or use supplies that meet the franchisor s
specifications even when the franchisee has complete freedom to chose the supplier and no revenue or other
benefits stream to the franchisor on account of the franchisee s purchases of those supplies. The 1999 commentary
9
section may be overly subtle. In the end, we think it is unlikely that the FTC meant to endorse a
narrower Item 8 disclosure than NASAA. For both practical and legal reasons, practitioners
should follow the text in the Amended Rule and NASAA s 2008 Guidelines and not be confused
by each agency s commentary. As a practical matter, when a franchisor derives no revenue on
account of a franchisee s purchases from suppliers of its own choosing, then the revenue and
percentages that the franchisor must disclose in Item 8 from required purchases or leases
remain unchanged. The proportionate percentages of required purchases or leases to start-up
and ongoing operating expenses may change, but presumably not materially. In either event,
since the percentages are just estimates, the franchisor should disclose a higher estimated
upper range if there is any doubt about what to count as a required purchase or lease.
b)
The Elements of Item 8 Sourcing Disclosures
There are 11 distinct areas of disclosure that FDD Item 8 must cover, some with multiple
subparts. Practitioners should refer to the exact language in the Amended Rule and NASAA s
Amended and Restated Guidelines, which are only summarized here. Despite some subtle
language differences noted above, this part of our paper assumes that federal and state laws
mandate identical Item 8 disclosures.29
(1)
If the franchisor imposes sourcing restrictions either by (i) designating the
supplier; (ii) forbidding the franchisee to purchase supplies except from suppliers who are
approved by the franchisor in advance; or (iii) imposing comprehensive specifications for the
particular goods or services that the franchisee may or must use, then the franchisor must make
a separate disclosure for each good or service. Item 8 covers restrictions applicable to anything
relevant to operating the franchise business, which spans the gamut from goods, services,
supplies, fixtures, equipment, inventory, computer hardware and software, real estate, or
comparable items.
Although the disclosure guidelines applicable to Item 8 require the
franchisor to specify each good and service for which specifications are imposed, even the
sample disclosures in the commentaries issued by the FTC and NASAA identify sourcerestricted supplies categorically in the broadest terms, e.g., a franchisor may disclose
restaurant equipment without itemizing the components by brand, type or supplier. The
franchisor need not disclose goods/services which the franchisor furnishes as part of fees which
the franchisor discloses in Items 5 or 6, such as initial training provided as part of the initial
franchise fee, or intellectual property for which the consideration is the franchisee s payment of
ongoing royalties or service fees.
(2)
To expose any potential conflicts of interest, Item 8 must disclose if the franchisor
or its affiliates are among the suppliers that the franchisor will approve for a particular
good/service or if they are the only approved supplier of a particular good/service.
addressed a different issue: whether Item 8 covers the situation where the franchisee chooses to buy generic
supplies, i.e. supplies for which the franchisor issues no specifications, from the franchisor (answer: no). The
example in the 1999 commentary concerned a fast-food franchisee s voluntary decision to buy generic drinking
straws from the franchisor. The issue raised in the text of this paper is whether a franchisor must identify as a
sourcing restriction a requirement that the fast-food franchisee use blue drinking straws of a certain length, width and
material if the franchisee is free to buy the blue drinking straws from any source capable of meeting the franchisor s
specifications and derives no revenue from the franchisee s purchases of blue drinking straws.
29
For Item 8 of the Amended Rule, see Bus. Franchise Guide (CCH) ¶ 6015. For NASAA s version of Item
8, see Bus. Franchise Guide (CCH) ¶ 5705.
10
(3)
As noted, the franchisor must disclose any supplier in which an officer of the
franchisor owns an interest. The franchisor need not identify the officer or the amount of the
ownership interest, but must name the supplier. The franchisor may wish to indicate when the
supplier is a public company or if the officer s ownership interest is less than a controlling
interest.
(4)
If the franchisor permits the franchisee to purchase or lease supplies from other
sources besides suppliers that the franchisor may designate or recommend, referred to in Item
8 as alternative suppliers, then the franchisor must disclose the fees payable and process
involved to obtain approval.
(5)
If the franchisor issues specifications and standards for goods/services, then the
franchisor must disclose how it provides this information to franchisees. Typically, a franchisor
would supply this information in updates to a confidential operating manual, which would be all
that a franchisor would have to say in Item 8 to meet the disclosure obligation.
(6)
The franchisor must disclose the precise basis by which the franchisor or its
affiliates will, or may, derive revenue or other material benefits from required purchases or
leases of goods/services. Required purchases and leases are those from designated or
approved suppliers whether or not affiliated to the franchisor. Other material benefits need not
be cash, but could be preferred financing terms or discounts extended by an approved supplier
even when the benefit has no immediate cash equivalence. Revenue must be disclosed in two
different ways: (i) the aggregate dollars received during the last fiscal year from all direct or
indirect franchisee transactions with designated or approved suppliers, and (ii) as a percentage
of the franchisor s total revenues from all sources whether or not related to franchise activities.30
Revenue includes payments from all sources on account of franchisee transactions whether
denominated as a rebate or something else. Reportable revenue includes "pass-through" sales
to franchisees; i.e., revenue the franchisor receives on its own direct sales of supplies to
franchisees with or without profit or mark-up, since the revenue appears on the income side of
the franchisor s audited financial statement despite the countervailing expense offset for the
cost of goods sold. Revenue data must be separately disclosed for the franchisor and each
affiliate that receives revenue on account of franchisee transactions with suppliers. The
franchisor s revenue data must be pulled from the franchisor s most recent audited financial
statements. However, affiliate revenue data may be pulled from the affiliate s unaudited
financial statements when the affiliate lacks its own audited financial statements.
(7)
The franchisor must disclose the magnitude of sourcing restrictions on a
franchisee s operating expenses by estimating the percentage of required purchases and leases
to the franchisee s overall cost to establish the franchise business disclosed in Item 7, and to
monthly operating expenses. These two percentages may be quite different. For example,
while the purchase of expensive restaurant equipment from a designated supplier might
comprise a significant percentage of a franchisee s start-up costs, the franchisee s ongoing
expenses to maintain the equipment would probably be just a negligible percentage of its overall
monthly operating expense. At the same time, the purchase of start-up inventory might
comprise a small percentage of a franchisee s start-up costs, but a more significant percentage
of its monthly operating expense. Both percentages may be estimates, A franchisor with
affiliate-owned outlets comparable to franchisee operations should take its own operating
30
Since most franchisors form a separate business entity to administer the franchise network, reportable
supplier revenue would be measured against revenue from franchise activities.
11
results into account in formulating these estimates whether or not it has current, reliable
franchisee data.
(8)
If a designated supplier will make payments to the franchisor from franchisee
purchases, the franchisor must disclose the payment either as a percentage of a franchisee s
purchase or as a flat amount, or disclose the cash equivalent benefit, e.g., the discount that it
receives from suppliers in its own purchases of similar goods/services.
(9)
The franchisor must disclose the existence of any purchasing or distribution
cooperatives and whether they are administered by the franchisor or an affiliate or by a
franchisee-owned group.31 The disclosure is intended to cover any organized group purchasing
arrangements, including franchisee-organized cooperatives, so that the franchisee can evaluate
the benefits of belonging to the franchise network. A cooperative is a distinct business
organization which is owned and controlled by the individuals who use the organization s
goods/services. Although the Amended Rule uses the phrase cooperative organizations in
referring to one of the four non-franchise relationships that the FTC continues to exclude from
the Amended Rule s coverage, Item 8 refers to cooperatives in a non-technical sense.
Nothing in the FTC s 2007 Compliance Guides or in NASAA s 2008 Commentary indicates that
Item 8 disclosures about cooperatives are limited to purchasing or distribution arrangements
conducted by a specific type of dedicated business entity owned and controlled by its members.
(10) The franchisor must disclose if it negotiates purchasing arrangements with
suppliers, including price incentives for network members. Item 8 need not disclose the price or
other purchase terms. The disclosure is not expressly confined to a contractual duty to
negotiate purchasing arrangements in the same way that Item 11 is confined to a franchisor s
pre-opening and post-opening obligations to provide assistance. Therefore, the Item 8
disclosure may be framed in terms of the franchisor s intentions, e.g., purchasing assistance
that the franchisor may provide. Unless a start-up franchisor knows that it will never provide
purchasing assistance or a seasoned franchisor has never in the past provided purchase
assistance despite claiming that it might do so one day, the franchisor should not be guilty of
negligent misrepresentation or fraud should it disclose the possibility of providing assistance in
this area sometime in the future, but fall short of delivery.
(11) The franchisor must disclose if it conditions material benefits, for example
renewal or granting additional franchises, based on a franchisee s decision to purchase
particular goods/services or use particular suppliers.
Presumably "material benefits"
encompasses other favors, such as credit terms on purchases.
c)
Identity of Suppliers
Although sample disclosures in the FTC s 2007 Compliance Guides and in NASAA s
2008 Guidelines identify designated suppliers, neither the Amended Rule nor the 2008
Guidelines specifically require franchisors to identify by name its designated suppliers, suppliers
who pay rebates or suppliers with whom the franchisor has negotiated special purchasing
31
When buying groups are formed by potential competitors, a variety of antitrust issues may arise.
Franchisee-led buying groups fall within this category since neighboring franchisees who may collaborate as buying
group members on issues like marketing programs, pricing and vendor agreements may also compete with each
other at the retail level for customers. For an excellent review of the potential antitrust issues, see Michael A.
Lindsay, Antitrust and Group Purchasing, 2009 A.B.A. SEC. ANTITRUST 66.
12
arrangements. NASAA clarified this in 1994 in commentary to the 1993 UFOC Guidelines.
Nothing issued by either the FTC or NASAA since then indicates a policy change.
d)
Alternative Suppliers
Although not specifically defined, an alternative supplier is a supplier, other than a
designated supplier, from which a franchisee may not complete a purchase unless and until the
franchisor approves the supplier. Typically, approval considers two separate issues: (i) the
quality of goods/services that the supplier has to sell and whether they meet prescribed
specifications; and (ii) the supplier s trade reputation and financial condition. Sometimes a
franchisor will condition its approval on the supplier s ability to demonstrate the ability to meet
the purchasing needs of neighboring franchisees or the entire chain.
e)
Revenue from Franchisee Transactions
As noted, the franchisor must disclose its revenue from franchisee purchases stated
both as aggregate dollars and as a percentage of total revenue from all sources. The franchisor
must also disclose if it receives non-revenue material benefits, such as volume discounts or
other preferred purchasing terms, on account of a franchisee s purchases.
f)
Remedies for Franchise Disclosure Violations
While there is no private right of action for violation of the Amended Rule s disclosure
requirements, which only the FTC may enforce, private parties may have remedies under state
unfair trade laws based on violations of the federal disclosure law, as addressed further in
Section IIIB.3. The FTC has broad enforcement powers to punish franchise law violators and
may freeze assets, order restitution, issue cease and desist orders, ban violators from selling
franchises, and recover substantial penalties.
Violation of state franchise sales laws carry significant penalties even if the franchisor
has no intent to violate the law. Not only is it a felony to sell a franchise without complying with
pre-sale disclosure or other requirements of a state franchise sales law, but state franchise
agencies have comparable enforcement authority to the FTC with equivalent remedies.
Franchisees have private remedies for state franchise law violations. Besides compensatory
damages and, in some states, attorney s fees, an injured franchisee may (i) rescind a franchise
agreement for disclosure and registration violations, including fraud in connection with a
franchise sale, and/or (ii) recover damages or restitution. Federal and state franchise laws
impose personal, joint and several liability on the franchisor s management and owners even
when the franchisor is a legal entity unless they can prove that they lacked knowledge of the
conduct constituting the violation and should not have known about it.
g)
Tubby's #14, Ltd. v. Tubby's Sub Shops, Inc.32
in the Pitfalls of Sub-Par Disclosures
A Case Study
For franchisors, the nuisance value of litigation over pre-sale disclosures cannot be
overstated. This is particularly true considering that avoiding liability for pre-sale disclosures
may be as simple as disclosing pre-contract in the broadest of terms that the franchisor may
32
No. 04-70918, 2006 U.S. Dist. LEXIS 69553 ( E.D. Mich. Sept. 27, 2006).
13
control supply sources, impose compulsory purchasing programs, profit from these programs
and modify all of these arrangements during the franchise term.
A good example of a disclosure lawsuit s nuisance is the Tubby s case. Franchisees of
Tubby s Sub Shop sued their franchisor over allegedly not disclosing its profits from a
mandatory distribution program.
The franchisees claimed Tubby s selected mandatory
suppliers based on their willingness to pay Tubby s a kick-back. Additionally, Tubby s set up a
subsidiary, SDS, to purchase products from selected suppliers and resell them to franchisees at
a significant mark-up, thereby profiting yet again from franchisee purchases. The franchisees
maintained that Tubby's had failed to adequately disclose its plans to profit from these supplier
arrangements.
While Tubby s disclosure document identified SDS s warehousing and
distribution services, Item 8 failed to disclose the revenues which Tubby s and SDS each
derived from franchisee purchases of supplies. The court denied Tubby s motions for summary
judgment finding that not only did the allegations support a claim under the Michigan Franchise
Investment Law for disclosure violations, but the facts were independently actionable as an
unfair and deceptive practice and common law fraud.
The court also refused to summarily dismiss the plaintiffs common law contract claim
based on a franchise agreement provision which plaintiffs argued limited Tubby s rebates from
suppliers to 2% of product sales to franchisees. Plaintiffs alleged that Tubby s rebates greatly
exceeded the 2% limit.
The reported history of the case, which was originally filed in 2004, extends through
2007 with the second denial of Tubby s motions for summary judgment. By the time of the final
reported episode of this case, two of Tubby s officers and directors had been reinstated as
defendants under the individual personal liability sections of the Michigan Franchise Investment
Law, which meant that, alone or together, they could have been held responsible for the
corporate franchisor s offenses. This significantly raised the stakes of the case and in all
likelihood propelled Tubby s to reach some type of out-of-court settlement three years and likely
tens of thousands of dollars later in attorney fee expenses.33
2.
Sourcing Restrictions in State Franchise Relationship Laws
Of the approximately 24 states that have some form of franchise relationship law
applicable to franchises generally (and not limited to a specific type of product or industry), only
four, Hawaii, Indiana, Iowa and Washington, have provisions directed at sourcing restrictions.
33
Coincidentally, other franchise sandwich chains have found themselves litigating similar issues involving
the quality of their Item 8 disclosures. In C.K.H., L.L.C. v. Quizno's Master, L.L.C., No. 04-RB-1164, 2005 U.S. Dist.
LEXIS 42347 (D. Colo. 2005), franchisees unsuccessfully tried to predicate a breach of contract claim on Quizno s
UFOC Item 8 disclosure, which stated that Quizno s negotiates arrangements with suppliers for the benefit of
Franchisees, which often include volume discounts." Id. at *11. Plaintiffs argued that the UFOC disclosure was
tantamount to a contract which Quizno s had breached by not passing on supplier rebates to franchisees. The court
dismissed the count based on another UFOC disclosure in which Quizno s expressly reserved the right to receive
revenue on account of franchisee-supplier transactions. The court also dismissed plaintiff s fraud claim based on the
same facts. In SubSolutions, Inc. v. Doctor's Assocs., 436 F. Supp. 2d 348, 355 (D. Conn. 2006), discussed infra, the
franchisor of the Subway chain ultimately prevailed in defending the adequacy of its pre-contract disclosures in which
it reserved the right to change its product requirements and approved vendors and specified that it could, in its
discretion, require its franchisees to purchase products from particular vendors. In Schlotzsky s, Ltd. v. Sterling
Purchasing and Nat l Distribution Co., Inc., 520 F.3d 393 (5th Cir. 2008), a terminated distributor excluded from future
business with Schlotzsky s franchisees unsuccessfully challenged the franchisor s sourcing restrictions not on the
basis of the franchisor s pre-sale disclosures, but as an illegal tying arrangement. Id. at 404-05.
14
The Hawaii34, Indiana35, Iowa36 and Washington37 statutes each contain provisions that address
tying arrangements by prohibiting or limiting a franchisor s ability to require a franchisee to buy
goods or services from designated sources. There is relatively little case law interpreting the
sourcing restrictions enacted by these states.
The Hawaii statute allows franchisors to designate suppliers if the restrictive purchasing
arrangement is reasonably required for a purpose justified on business grounds. There do not
appear to be any reported cases that offer guidance as to the meaning of reasonably
necessary or justifiable business grounds. Hawaii s relationship law also forbids a franchisor
from deriving money or anything else of value on account of third party supplier transactions
with franchisees unless the franchisor advises the franchisee in advance of the franchisor's
intention to receive such benefit. 38 An Item 8 disclosure would therefore remove the risk of
independent liability under Hawaii s relationship statute.
The Indiana law makes it unlawful for a franchisor to require franchisees to buy supplies
or services exclusively from the franchisor or another designated source when items of
comparable quality are available from other sources. Indiana s law expressly allows sourcing
restrictions with respect to a franchisor s principal goods and services. In Stevens v.
Physicians Weight Loss Centers of America, Inc.,39 a franchisee sued its franchisor under this
statute based on the required purchase of various goods. The court differentiated among the
products which were subject to the franchisor s sourcing controls, finding that the franchisee
could be compelled to purchase the franchisor s brand of nutritional supplements because these
trademarked goods were an inseparable and mandatory part of the business. However, the
court ruled the other way on the forced purchase of a specific brand of carpet, finding that, in
contrast to the nutritional supplements, carpeting could not be considered a principal good. 40
The Indiana law also bars franchisors from coercing franchisees to order or accept
delivery of any goods, supplies, inventories, or services which are neither necessary to the
operation of the franchise, required by the franchise agreement, required by law, nor voluntarily
ordered by the franchisee. In Carrel v. George Weston Bakeries Distribution, Inc.,41 the court
34
HAW. REV. STAT. tit. 26, ch. 482E, § 482E-6(2)-(2)(B).
35
IND. CODE tit. 23, art. 2, ch. 2.7, § 1(1).
36
IOWA CODE tit. XIII, ch. 523H, § 523H.12(1).
37
WASH. REV. CODE tit. 19, ch. 19.100, § 19.100.180(2)-(2)(b). The closest a court appears to have come to
analyzing Washington s restrictive sourcing law is Nelson v. National Fund Raising Consultants, Inc., 842 P.2d 473
(Wash. 1992), Bus. Franchise Guide (CCH) ¶ 10,179. The case involved a related provision, Washington Revised
Code, Title 19, Chapter 19.100, § 19.100.180(2)(d), which prohibits selling, renting, or offering to sell to a franchisee
any product or service for more than a fair and reasonable price. The court held that the defendant violated this
provision by charging a markup on required supplies. Id. at 475-477. The trial court had found a violation of the
sourcing restriction provision, § 19.100.180(2)(b), in this same behavior, but the Washington Supreme Court declined
to reach the issue because it decided the matter based on the overcharges. Id. at 475.
38
Section 482E-6(2)(D).
39
Bus. Franchise Guide (CCH) ¶ 10,739, Nos. 5:91 CV 0272, 5:91 CV 0495 (N.D. Ohio Aug. 21, 1995).
40
Id.
41
2007-2 Trade Cas. (CCH) ¶ 75,934, No. 1:05-CV-1769-SEB-JPG, 2007 U.S. Dist. LEXIS 72353 (S.D. Ind.
Sept. 25, 2007).
15
denied summary judgment for the defendant and allowed a distributor s claim to go forward
based on evidence that the bakery manufacturer s plussing up practice forced distributors to
buy excess inventory that the distributors had not ordered.
Indiana law also forbids a franchisor from obtaining anything of value, other than for
compensation for services rendered by the franchisor on account of a third party supplier s
transactions with a franchisee unless the benefit is promptly accounted for, and transmitted to
the franchisee. 42 Unlike similar laws in Hawaii and Washington, the franchisor gains no
defense to liability by disclosing the arrangement to the franchisee.43 The specific section has
apparently not yet been the subject of reported judicial interpretations.
At least on its face, the Iowa statute seems to be the most restrictive of the four. It
prohibits sourcing restrictions where goods or services of comparable quality are available from
other sources. A franchisor may only require its franchisees to purchase reasonable quantities
of supplies, including display and sample items, from the franchisor or its affiliate when the
supplies are central to the franchise business and are either actually manufactured or
produced by the franchisor or its affiliate or incorporate the franchisor s trade secret. Like the
other states with relationship laws addressing sourcing restrictions, Iowa s statute allows
franchisors to maintain quality standards and targets restrictive purchasing arrangements.
There do not appear to be any cases interpreting Iowa s restrictive sourcing prohibitions.
Washington s statute is similar to Hawaii s in that it allows restrictive purchasing
agreements as long as they are reasonably needed for business purposes, although
Washington adds that such restrictions cannot substantially affect competition. Washington s
law does not apply to the franchise s initial inventory, and it notes that federal antitrust law
should provide guidance for interpreting the state s rules. Washington s law also forbids
franchisors from receiving anything of value on account of a third party supplier s transactions
with a franchisee unless the franchisor discloses the arrangement. Although not articulated in
the statute, the Washington Supreme Court interpreted this section to mean that, to be effective,
the disclosure must occur before the franchise is sold.44 A recent law review article states that
the clear intent of Washington s restrictive sourcing statute is to forbid only those arrangements
that would constitute an illegal tie-in under the federal Sherman or Clayton Antitrust Acts, and
that in practice it will have little impact on supply restrictions. 45
42
IND. CODE tit. 23, art. 2, ch. 2.7, § 1(4), CCH BFG ¶ 4140.01.
43
The only reported decision that we have found addressing this section of the Indiana Deceptive Franchise
Practices Act is Kinnard v. Shoney's, Inc., 100 F. Supp. 2d 781 (M.D. Tenn. 2000), in which the facts did not give rise
to a claim under § 23-2-2.7-2(6) in that the court found that the rebates which the franchisor received from third party
suppliers were not the direct result of supplier-franchisee transactions. The court did note that the section required
the franchisor to provide an accounting of benefits or money received from third party supplier-franchisee
transactions. Id. at 797. The case did not need to discuss the kind of services a franchisor might perform to
legitimize the supplier restrictions.
44
Section 19.100.180(2)(e); Nelson v. National Fund Raising Consultants, Inc., 120 Wn.2d 382, 391 (Wash.
1992) (noting that [d]isclosure of a contract's terms, to be meaningful, must occur before contract formation, not after
the parties have become contractually bound, citing the Restatement (Second) of Contracts).
45
Douglas C. Berry, et al., State Regulation of Franchising: The Washington Experience Revisited, 32
SEATTLE U. L. REV. 811, 877-78 (2009).
16
B.
Antitrust Law and Sourcing Restrictions
1.
General Overview
The antitrust issue most directly implicated by franchisor-imposed sourcing controls is
tying claims, which are addressed by Section 1 of the Sherman Act,46 Section 3 of the Clayton
Act,47 and Section 5 of the FTC Act.48
In the classic tying arrangement, a seller conditions the sale of one product or service
(the tying product ) on the buyer s purchase of a separate product or service (the tied
product ). In challenging sourcing restrictions as illegal tying arrangements, franchisees have
typically argued that the franchisor has unfairly used its dominant position as trademark licensor
to force the plaintiffs to buy goods or services that they either do not need or want, or would
prefer to buy from another source on better terms, leaving them competitively disadvantaged.
To prevail on a tying claim, a plaintiff must show that the defendant had over a 30% share of the
market in the tying product. Though sourcing restrictions can be pro-competitive in that they
enable an individual franchisee to leverage the buying power of the chain, they can also have a
deleterious polarizing effect on a franchise network when franchisees receive no real economic
benefit from the restrictions either through lower prices or improved access to the tied supplies.
Generally, most of the practices that have been characterized as tying arrangements
involve exclusive dealing, an independently actionable claim under the Sherman, Clayton and
FTC Acts.49 Efforts to challenge franchise sourcing restrictions as illegal exclusive dealing
arrangements have generally failed.50 In the classic exclusive dealing, a buyer commits to
purchase goods or services solely from one seller to the exclusion of the seller s competitors for
an extended time period foreclosing competing suppliers from access to the buyer. To prevail
on an exclusive dealing claim, the plaintiff must also show that the defendant had over a 30%
market share in the relevant market to establish a presumption that the arrangement lessened
competition. Courts often confuse tying and exclusive dealing doctrines despite clear
differences.51 Unlike an exclusive dealing arrangement, a tying arrangement requires a tied-up
purchaser to buy unwanted goods as a condition to purchasing the tied product, but does not
specifically forbid the purchaser from selling a competitor s goods. Unlike a tying arrangement,
an exclusive dealing arrangement does not require a purchaser to buy unwanted goods; but
forbids the purchaser from buying equivalent goods from the seller s rivals. While the most
46
Sherman Antitrust Act, 15 U.S.C. §§ 1-7.
47
Clayton Antitrust Act, 15 U.S.C. §§ 12-27; 29 U.S.C. §§ 52-53.
48
Federal Trade Commission Act, 15 U.S.C. §§ 41-58.
49
See 11 PHILLIP E. AREEDA, ANTITRUST LAW ¶ 1800b. (2007) (comparing judicial treatment of tying and
exclusive dealing claims in the context of licensing arrangements).
50
See Michael J. Lockerby, Franchising After Leegin: A License to Fix Prices?, 27 FRANCHISE L.J. 112
51
See AREEDA, supra note 49, at ¶ 1800b. (noting that courts sometimes confuse the two legal doctrines).
(2007).
17
frequent plaintiff in a tying case is the tied-up buyer, in an exclusive dealing case it is the
excluded rival.52
While tying and exclusive dealing cases both limit supplier choices of affected
franchisees, if the market in which affected franchisees resell their products or services remains
competitive, the ultimate consumer remains unaffected. As a result, most franchise tying or
exclusive dealing cases can, or should, be dismissed at the pleading stage due to the absence
of a necessary element of proof: demonstrable consumer injury.53 This outcome seems
appropriate considering that it is not the purpose of the antitrust laws to regulate the content of
distribution contracts except in the unusual case when competition is impaired. 54
When it comes to complaints about sourcing restrictions, the franchisee s real gripe is
not about being held captive to deal exclusively with the franchisor or its designated supplier,
but about compulsory tie-ins. We direct the reader to other papers which elaborate on the
application of exclusive dealing claims in the context of sourcing controls and focus the rest of
this Section on tying arrangements.55
Other antitrust issues arise in franchise relationships, but do not directly grow out of
sourcing controls. A franchisor may insist that franchisees adhere to specific retail pricing or
price floors or ceilings even when they are permitted to buy all of their supplies from third parties
of their own choosing. Claims charging the franchisor with discriminating among, or against,
franchisees in the price of goods sold, promotional allowances or vendor rebates in violation of
the federal Robinson-Patman Act56 can arise absent any sourcing restrictions, where
franchisees may purchase goods from third party approved suppliers, but choose instead to buy
them from the franchisor or its affiliate.
2.
Tying Arrangements
Since modern franchising s explosive growth starting in the 1960s, judicial hostility to
restrictive purchasing arrangements has all but disappeared. In the early years, courts were
52
Id. at ¶ 358a. ( Although the health of foreclosed suppliers and the vitality of competition in their market is
the central concern of tying law, the immediate victim of the restraint is the customer who is forced to take a product it
does not want. That customer is the usual plaintiff
). Occasionally, the plaintiff in a tying case is an excluded
supplier. See Schlotzsky s, Ltd. v. Sterling Purchasing & Nat l Distribution Co., Inc., 520 F.3d 393, 404-05 (5th Cir.
2008) (in which the court rejected the terminated distributor s tying claim based on the finding that the franchisor had
exercised its contractual right to control the supply sources). While the terminated distributor fashioned a tying claim
against Schlotzsky s, it reads more like an exclusive dealing challenge.
53
See AREEDA, supra note 49, at ¶ 1800b.
54
Id.
55
See, e.g., Erika Amarante & Mark McLaughlin, The Top 10 Things Every Franchise Company Needs to
nd
Know About Antitrust and Competition Law: Everything from Pricing to the Supply Chain, presented at the 42
Annual Legal Symposium of the International Franchise Association (2009); Patrick J. Maslyn & W. Andrew Scott,
h
Contractual and Business Aspects of Structuring Supplier Agreements, presented at the 30th Annual Forum on
Franchising (2007); Michael K. Lindsey & Suzanne E. Wachsstock, A Practical Guide to Franchising and Antitrust,
th
presented at the 29 Annual Forum on Franchising (2006).
56
Robinson-Patman Act, 15 U.S.C. §§ 13-13b, 21a.
18
receptive to franchisee tying claims challenging franchisor-imposed sourcing restrictions.57
Franchisors were presumed to have the requisite economic power to compel franchisees to buy
unwanted goods based on their ownership of the licensed brand name, the franchise system s
cornerstone.58
However, the judicial pendulum has since clearly swung in the other direction. Two
cases, in particular, deserve responsibility for nearly knocking out tying claims in the franchise
context. The 1984 Supreme Court decision in Jefferson Parish Hosp. Dist. No. 2 v. Hyde,59 a
non-franchise case, ruled that a plaintiff must demonstrate that a defendant enjoys at least a
30% share of the tying product market in order to establish a tie-in arrangement s per se
illegality.60 As a result of Jefferson Parish, tying contest became an initial battle over the proper
definition of the relevant market. Efforts to define the relevant market as a single franchise
brand nearly always failed.61 For all intents and purposes, Jefferson Parish doomed the
franchise trademark case: Virtually no franchisor s franchise offering enjoys anything close to a
30% share of any sensibly defined relevant market. 62
Eastman Kodak Co. v. Image Tech. Servs.,63 a non-franchise case, briefly revived
franchise tying cases by allowing franchisees to demonstrate their franchisor s substantial
market power as a brand-specific relevant market.64 The Supreme Court found that even
though Kodak lacked market power in the tying product, Kodak copiers, it had market power in
the tied-product, branded replacement parts. When Kodak adopted a restrictive policy that hurt
the ability of independent service providers of Kodak copiers to purchase replacement parts, the
independent providers sued, alleging that Kodak s opportunistic policies forced them out of
business. Their customers who owned Kodak copiers were locked in and disinclined to switch
to another brand of copier at that point given that the initial cost of purchase was prohibitively
high. In the post-contract period, Kodak could exploit its dominance over the independent
service providers even though it lacked market power in the tying product, copiers. The
Supreme Court, therefore, rejected Kodak s motion for summary judgment and thereby
breathed new life into franchise tying claims.
57
Arthur I. Cantor & Peter J. Klarfeld, An Unheralded Stake Through the Heart of Siegel v. Chicken Delight
and a New Climate for Franchise Tying Claims, 28 FRANCHISE L.J. 11, 12 (2008).
58
Siegel v. Chicken Delight. Inc., 448 F.2d 48 (9th Cir. 1971) is the leading example of the hospitable
climate for tying claims in the early years of modern franchising. The Ninth Circuit unanimously affirmed a tying
decision against the franchisor, ruling that the franchisor would be presumed to have the requisite market power
based on ownership of the licensed trademark.
59
446 U.S. 2 (1984).
60
Id. at 16.
61
See, e.g., Queen City Pizza, Inc. v. Domino s Pizza, Inc., 124 F3d 430, 433 (3d Cir. 1997); Schlotzsky s,
Ltd. v. Sterling Purchasing & Nat l Distribution Co., Inc., 520 F.3d 393, 404-05 (5th Cir. 2008).
62
Cantor & Klarfeld, supra note 57.
63
504 U.S. 451 (1992).
64
Id. at 461.
19
Kodak s revival of franchise tying claims was short lived. Five years later, Queen City
Pizza, Inc. v. Domino s Pizza, Inc.65 dealt a knock-out punch by sanitizing sourcing restrictions
when the franchisor discloses them to prospective franchisees before they buy the franchise,
regardless of whether the tying goods or services possess unique qualities or suitable
alternative suppliers exist capable of selling the same or comparable goods at lower prices. In
deciding Queen City, the Third Circuit identified the source of the franchisor s economic power
as the franchise agreement. It was the contract, not the marketplace, which gave Domino s the
absolute right to establish specifications for all pizza ingredients, beverage products, cooking
materials, containers, and everything else that franchisees needed to operate their business.
The contract similarly gave Domino s the right to insist that franchisees purchase these items
exclusively from Domino s or approved suppliers, which Domino s could limit in number. When
Domino s refused to share its specifications with suppliers selected by franchisees, the plaintiffs
sued, alleging a variety of antitrust claims. The court rejected the plaintiffs claims, finding that
Domino s had acted entirely pursuant to its contractually reserved rights. Its authority emanated
from the franchise agreement, not because of its market share, which undisputedly was under
30%. Absent the requisite level of market power, the plaintiff s tying claims had to be
dismissed.66
Of course, Queen City did not put an end to new franchise tying cases. Plaintiffs since
Queen City have tried to fashion their claims within the specific contours of Kodak as postcontract sourcing restrictions by asserting a very narrow market definition limited to the
franchise brand.67 They have tested the quality of the franchisor s pre-contract disclosures
about sourcing controls and the franchisor s intentions regarding profiting from franchiseesupplier transactions.68 As explained in Section VI, which addresses best practices in drafting
franchise agreement provisions pertaining to sourcing restrictions, if franchise tying cases
remain viable at all, the crucial issue will be the quality of pre-contract disclosures.
65
124 F.3d 430 (3d. Cir. 1997). Plaintiffs brought separate claims for monopolization under Sherman Act
Section 2, exclusive dealing under Sherman Act Section 1, and illegal tying under Sherman Act Section 1. As for the
tying claim, the court affirmed the lower court s analysis: "Plaintiffs do not and cannot purchase ingredients and
supplies from alternative suppliers not because Domino's dominates the ingredient and supply market or because
Defendant is the market's only supplier, but because the franchisee-plaintiffs are contractually bound to purchase
only from suppliers approved by Defendant. It is economic power resulting from the franchise agreement, therefore,
and not market power, that defines the 'relevant market' Plaintiffs allege in support of their antitrust claims." Id. at
435.
66
For a recent franchise tying case that echoes this point, see Arnold v. Petland, Inc., No. 2:07-cv-01307,
2009 U.S. Dist. LEXIS 31377 (S.D. Ohio Mar. 26, 2009).
67
See Allan P. Hillman, Franchise Tying Claims: Revolution Or Just A "Kodak Moment"? 21 FRANCHISE L.J.
1 (2001). Hillman discusses Kodak, Queen City, and post-Queen City tying cases based on Kodak s rescue of
franchisee tying claims from the dustbin of history. Id. at 46. Clearly, the massive precontractual disclosures
required of franchisors compares favorably to the lack of precontractual disclosure in Kodak. Every circuit court
considering the matter has agreed that, had Kodak's policy been known precontract, the result would have been
different. Id. at 45. See also BLAIR & LAFONTAINE, supra note 1, at 157 (discussing the pre-contract and post-contract
perspectives after Kodak.)
68
See Hillman, supra note 66. The author laments: According to decisions like Queen City, the power to
exploit franchisees economically during the life of a contract typically stems from the contractual relationship rather
than from dominance in a unique market, such as the market for Kodak parts or services. Yet this rationale, an
almost blanket rejection of franchise tie-ins, asks too much and cannot be reconciled with [post-Queen City cases]
Wilson, Little Caesar, Collins, or SubSolutions, much less with Kodak itself. Id. at 45.
20
Legal challenges addressing sourcing restrictions imposed by a franchisor after the
contract s formation have also been seriously eroded. The 2006 Supreme Court decision in
Illinois Tool Works, Inc. v. Independent Inv., Inc.69, a non-franchise case, overruled prior
Supreme Court decisions holding that patents should be presumed to signify a patent owner s
market power for purposes of tying analysis. In so ruling, the Supreme Court eliminated the
analogical basis on which early franchise tying cases found that franchisors, as trademark
licensors, had presumptive market power. Since legally cognizable market power cannot arise
out of the franchise contract itself, a plaintiff needs to be able to prove that a single franchise
brand enjoys a 30% market share in order to sustain a tying claim under the Sherman Act, a
threshold which no franchise network, even the largest, enjoys today.70
3.
State Little FTC Acts
Deficient disclosures about sourcing restrictions may also be redressed under state little
FTC Acts when a plaintiff can demonstrate that the disclosure misrepresented the true facts and
therefore was deceptive under the standards set by these statutes. Alternatively, if the
deficiency violates the Amended Franchise Rule, many state little FTC Acts incorporate by
reference the deceptiveness standard established by the FTC. Through this type of analytical
"bootstrapping, a private plaintiff may be able to state a claim under a state little FTC Act based
on disclosures that are deceptive or fail to meet the federal disclosure guidelines even though
the private plaintiff would have no private right of action for violation of the Amended Franchise
Rule itself. This "bootstrapping approach has had mixed results in state courts."71
Additionally, in the dozen or so states that regulate franchise sales, deficient and
deceptive disclosures about sourcing restrictions are actionable as a violation of the state
franchise sales law giving rise to civil, criminal and administrative remedies. The same
deceptive disclosures may also support common law fraud claims. Fraud-type claims are not
sure winners especially when allegations of deception emanate from post-contract changes in
sourcing arrangements and not from untrue statements made in the disclosure document
delivered pre-contract. To prevail in a claim for statutory fraud under a franchise sales law, a
franchisee must prove some degree of reasonable reliance on the inaccurate information in the
disclosure document that mislead its decision to buy the particular franchise. To prevail on a
common law fraud claim, the plaintiff must prove the franchisor s intended to deceive, which
may be impossible to establish if the franchisor s disclosure is, in fact, truthful when made.
69
547 U.S. 28 (2006).
70
See Comment, Intellectual Property Tying Arrangements: Has The Market Power Presumption Reached
The End Of Its Rope?, 57 DEPAUL L. REV. 539, 564-66 (2008). The article maintains that the presumption of market
power in trademark cases should be eliminated now that the courts have abandoned the presumption in patent
cases.
71
Compare, for example, SDMS, Inc. v. Rocky Mt. Chocolate Factory, Inc., 2008 U.S. Dist. LEXIS 90276
(S.D. Cal. Nov. 6, 2008) (dismissing claims for disclosure violations brought under California s little FTC Act and state
unfair competition law) and Randall v. Lady of Am. Franchise Corp., 532 F. Supp. 2d 1071 (D. Minn. 2007) (allowing
claims under the Minnesota Franchise Act, the Florida Franchise Act (forbidding misrepresentations in the sale of
franchises) and Florida s little FTC Act based on alleged deficient disclosures, omissions and unregistered earnings
claims).
21
While courts have suggested that franchise-related tying claims may be brought under
state little FTC Acts,72 these causes of action should not survive if the same underlying conduct
fails under a state or federal antitrust law. In Chavez v. Whirlpool Corp.,73 a California Court of
Appeal held that if the same conduct is alleged to be both an antitrust violation and an unfair
business act or practice for the same reason because it unreasonably restrains competition
and harms consumers the determination that the conduct is not an unreasonable restraint of
trade necessarily implies that the conduct is not unfair toward consumers. 74 Given that
California courts consider a tying arrangement disclosed in advance through a franchise
agreement to be part of a negotiated business relationship and not a restraint of trade, it
would appear that the arrangement cannot be an unfair business practice as a matter of law.75
IV.
BENEFITS ARISING FROM FRANCHISOR CONTROL OVER AND INVOLVEMENT IN
THE SOURCE OF PRODUCTS AND SERVICES
A.
Quality Control
The primary benefit arising from franchisor control over the source of products and
services is uniform product quality. As Nancy Kruse, from the restaurant consulting firm,
Technomic, notes: Travelers love to see fast food chains at airports. Even if they re 2000
miles from home, they can go into an airport McDonald s, order a Big Mac, and know exactly
what they re getting and more or less what it s going to cost. 76 Similarly, the founder of
Ember s America points out: If Big Macs were different from McDonald s to McDonald s,
people wouldn t stop at McDonald s very often. 77 In other words, customers become loyal if
the experiences they enjoy at diverse units of a chain routinely meet their expectations. 78
Since, by definition, a franchisor doesn t own and operate all of its outlets directly, it is
required to maintain uniform product quality through contractual provisions. These include
specific performance clauses, product specifications and input purchase requirements. Subway
franchisees, for example, must agree to adhere to Subway s quality control standards regarding
the goods and services sold to the customer.79 McDonald s franchisees must serve only
72
See Carquest of Hot Springs, Inc. v. General Parts, Inc., 238 S.W. 3d 916, 919 (Ark. 2006) (leaving open
the question of whether tying claim could be brought under Arkansas Deceptive Trade Practices Act); see also James
L. Petersen & Angela M. Fifelski, State Tying Claims: Do You Know What May Be Lurking?, 21 FRANCHISE L.J. 118,
124 (2002).
73
93 Cal. App. 4th 363 (2001).
74
Id. at 375.
75
Exxon Corp. v. Superior Court of Santa Clara County, 51 Cal. App. 4th 1672, 1686 (1997). See also
SubSolutions, Inc. v. Doctor s Assocs., Inc., 436 F. Supp. 2d 348, 357 (D. Conn. 2006) (dismissing franchisee s
claims under Connecticut little FTC Act because it produced no evidence beyond the alleged tying arrangement
itself, which formed the basis for the antitrust claims that the court had already rejected.)
76
BLAIR & LAFONTAINE, supra note 1, at 117 (quoting Frequent Flyer, March 1991).
77
Tim Johnson, Revitalization of the Mom & Pops, FRANCHISE TIMES, Feb. 1998, at 15-16.
78
BLAIR & LAFONTAINE, supra note 1, at 117.
79
Id. at 130.
22
designated food and beverage products that meet McDonald s specifications.80 Franchisees
may also be required to purchase all of their goods and services from approved vendors, or, in
some cases, from the franchisor itself. However it is accomplished, all franchise restrictions on
the source of products and services are fundamentally designed to provide a uniform quality
product to the customer.81
Sourcing restrictions also achieve the correlative benefit of eliminating franchisee freeriding, a problem endemic in franchising.82 Free-riding describes franchisee behavior which
deviates from brand standards in order to reduce personal operating costs without regard for the
brand damage that such behavior might cause. Individual franchisees have an incentive to cut
costs and supply low-quality products and services because they do not bear the full cost of any
resulting deterioration in the trademark's value. 83 Sourcing restrictions are an efficient means
to deter post-contractual free-riding opportunism by franchisees.84
B.
Competitive Pricing
Franchise system control over product sourcing also allows the franchisor to reduce the
cost of delivering supplies to its franchisees. These cost savings are primarily derived from two
participants in the supply chain: vendors and distributors.
By restricting the purchase of goods and services to approved vendors, the franchisor
can leverage all of the system s buying power and negotiate the lowest possible prices. First,
during contract negotiations, the franchisor can accurately represent its total purchasing volume
to potential vendors based on system-wide sales, thereby receiving the best possible price.
Second, the franchisor can fulfill its contractual purchasing obligations to the vendor, the terms
of which often include a minimum sales volume in order for the franchisor to receive the
vendor s best price. Third, by directly negotiating with vendors, rather than outsourcing this
function to brokers or a broadline distributor, franchisors can reduce product costs by
contracting with multiple vendor sources for the same product, e.g., Coca-Cola and PepsiCo for
beverages. This not only has the effect of keeping product prices low, it tends to concurrently
improve upon key non-price performance measurements, such as customer service, on-time
deliveries and invoice accuracy.
Franchisor involvement in distribution can also exact significant cost savings for
franchisees. For example, most QSR franchisors will designate an exclusive distributor for each
region and, to the extent possible, source all product through that distributor ( single source
distribution ). As most QSRs use under 100 ingredients per restaurant, the product line is
limited and it is easy for one distributor to guarantee supply. By designating a single distributor
within a region and sourcing all product through that distributor, the franchisor is able to
80
See 2006 Franchise Agreement, McDonald s USA, LLC ¶¶ 12(a), 12(i).
81
Blair & Kaserman, supra note 6, at 323.
82
See Uri Benoliel, The Expectation of Continuity Effect and Franchise Termination Laws: A Behavioral
Perspective, 46 AM. BUS. L.J. 139, 143-4 (2009) ( According to the law-and-economics perspective, the free-riding
problem typifies franchise contracts. )
83
Id. at 144-45.
84
BLAIR & LAFONTAINE, supra note 1, at 165.
23
negotiate the lowest possible delivery cost on a per product basis. This is because (1) the
distributor is able to maximize the number of drops per distance driven by each truck, (2) the
distributor is able to minimize the cost of inbound freight, as a greater number of full truckloads
are dispatched to a single distribution center, rather than splitting loads, and (3) the distributor is
better able to manage and track inventory, with greater velocities allowing it to optimize
purchases of short lived products.
In short, by taking advantage of economies of scale on both procurement and
distribution, the franchise system can provide the lowest delivered price on products and
services for its franchisees.
C.
Safety and Brand Protection
Franchisor involvement in the supply chain also increases accountability for the safety of
the products distributed. While vendors may be subject to various federal and state health and
safety requirements, franchisor vendor contracts typically require heightened protections above
and beyond these regulations, including immediate vendor reporting of unsafe products to the
franchisor, vendor and/or independent product testing, and product recall. This allows the
franchisor to place an early firewall between a potential dangerous product (e.g. meat
contaminated with Lysteria) and distribution of the product to the system.
Whether a franchisor procures product directly from a vendor or it chooses to outsource
this function, strict control over the source of products and services also lessens the opportunity
for harmful products to enter the system. For example, during the recent salmonella scare,
which focused erroneously on tomatoes (the source of the outbreak was later linked to chili
peppers), franchisors with (i) mandatory produce suppliers and (ii) a high level of system
compliance by their franchisees were able to ensure that the tomatoes they provided to their
franchise customers did not originate in the geographical area associated with the outbreak.
This allowed the franchise system to continue to supply consumer products made with tomatoes
with minimal risk of customer injury or harm to the brand.
D.
Commodity Smoothing
After years of price stability, beginning in 2007, the Producer Price Index (PPI) increased
dramatically, with fuel/power and farm products being impacted the most. Spurred by rapid
increases in producer prices, the price of flour nearly tripled year over year. For franchisors in
the restaurant sector, this resulted in a substantial increase of the cost of food purchased by
their franchisees. In its 2008 10K, for example, Dominos reported a year over year increase in
food and paper costs of 5.7 percent, a substantial amount in an industry in which food and
paper expenses are typically a franchisee s largest variable cost. QSR franchisees are
particularly vulnerable to such increases because it is often difficult for the franchise system to
pass them along to the customer, who has been conditioned to expect products at a specific
price point, whether $5 Footlongs or food from the Dollar Menu.
Consequently, one of the principal benefits franchisors can provide by involving
themselves in the supply chain is to bring price stability for their franchisees. Franchisors
primarily accomplish this through forward contracts with vendors, in which they lock in
commodity purchases over a lengthy period of time. Franchisors also accomplish price
smoothing by purchasing insurance in the form of a hedge for commodities such as cheese,
soybean oil or hard red spring wheat. While such measures can rarely guaranty the lowest
priced products at all times, they do allow a franchise system to lock in a steady supply of
24
products critical to franchise operations at a reasonable price, thereby lessening the business
risk to franchisees who would otherwise have little protection from price spikes for key inputs for
their business.
E.
On-going Product Availability
Franchisor involvement in the supply chain also provides greater assurance of product
availability. While a broadline distributor has vast resources, they may not always have the
products the system needs, particularly for promotions, limited time offers and new product
development. Franchisors can address this issue by setting up redundant vendor capacity and
by taking ownership of and responsibility for inventory. By putting its own balance sheet on the
line, managing its own inventory, and accepting the risk of loss on over-buys and product
returns, the franchisor can increase supply chain accountability to its franchisees, ensuring that
they always have the products they need, when they need them.
F.
Knowledge Management
Supply chain management requires a high-level of information sharing and coordination
among the constituent members of the supply chain..85 By centralizing sourcing, franchisors
can serve in the pivotal role of managing the knowledge flow among the supply chain
participants and the supplier s customers, i.e., the franchisees, and allow franchisors to
integrate their own market research to optimize successful supply chain execution.
G.
Localized Expertise and Rapid Response
The principal beneficiary of a well managed franchise supply chain may be the
franchisee. Franchisees need not become experts in negotiating, purchasing, managing
delivery costs and coordinating buying. Nor need franchisees be bothered by sales people
coming to their retail outlet at any hour they please in order to discuss new products. Instead,
franchisees can receive precisely the products that they need delivered to their store in a single
delivery, allowing the franchisee to dedicate his time to his business and to customer service.
When problems do arise, whether due to product quality or missed or incorrect deliveries, the
franchisee can address these problems directly with the franchisor, whose direct contractual
relationship with the vendor, logistics provider and distributor, coupled with the purchasing
power of the entire chain, allows the franchisor to obtain a more rapid response than any
franchisee could likely achieve working alone.
V.
TENSIONS ARISING FROM FRANCHISOR CONTROL OVER AND INVOLVEMENT
IN THE SOURCE OF PRODUCTS AND SERVICES
A.
Franchisee Purchases of Substandard or Unapproved Products
Most franchisees recognize the importance of product uniformity, and they will complain
about other franchisees who purchase substandard or unapproved products and will request
that the franchisor intervene.86 These franchisees understand that a franchisee who reduces
85
Russell T. Crook et al., Antecedents And Outcomes Of Supply Chain Effectiveness: An Exploratory
Investigation, J. OF MANAGERIAL ISSUES, June 22, 2008 (discussing how knowledge sharing across all participants in
the supply chain improves performance).
86
Jeffrey A. Tannenbaum & Stephanie N. Mehta, Bias at a Single Store Can Taint Franchise Chain s Image,
WALL ST. J., Mar. 6, 1997, at B2.
25
the quality of products he offers for a given price might increase his profits, yet by disappointing
buyer s expectations he could reduce by a greater amount the net returns to the common
intangible goodwill asset
maintained by the franchisor and used jointly by his other
87
franchisees. Nonetheless, the purchase of substandard or unapproved products is a perennial
problem for many franchise systems.
The root of the problem is that an individual franchisee s incentives may not be aligned
with those of the franchisor. Thus, a donut shop owner might reduce costs, and so enhance
profits, by selling rather than throwing away donuts that are not completely fresh. 88 This
problem can be particularly acute when a franchisee s customers are transient, such as those
with store locations in airports or adjacent to rural interstate highways, who, unlike stores
frequented by knowledgeable local customers, will continue to receive store traffic based on the
strength of the brand. Franchisees can also hurt the franchise system, not by using lower cost
products, but by catering too much to the needs of their local market . . . .89 [I]f McDonald s
franchisees offer Cajun burgers in New Orleans, teriyaki burgers in Honolulu, and Tex-Mex
burgers in San Antonio, customers will not know what to expect at other locations, which may
result in lower system-wide sales.90
As a result, even the gold standard of product uniformity, McDonald s, once grappled
with franchisees purchasing inferior food supplies in order to get a cheaper price and those
experimenting with new products, new procedures and new (and higher) prices. 91 For
example, McDonald s first true owner-operator husband and wife franchisee team, the Agates
whose undeniable success in the business led a number of their peers to become franchisees
themselves and helped [Ray Kroc, the founder of McDonald s System Inc., to] identify good
prospects at a critical juncture in the chain s development, became known as price buyers
franchisees who substituted cheaper products from non-approved suppliers 92. Ray Kroc
understood the importance of product uniformity. Consequently, after the Agates signed a deal
to sell Pepsi in their restaurant rather than the approved cola at McDonald s, Coca-Cola, Kroc
denied the Agates the opportunity to buy additional stores. Agate became known as the one
punished by Kroc for switching from Coke to Pepsi, and no other franchisee ever tried to make
that switch again.93 In the end, by refusing to renew licenses, refusing to grant new franchises
to existing franchisees, and suing franchisees for breach of contract (the latter of which was
virtually unheard of in franchising at the time), McDonald s set numerous precedents and
convinced the courts that for franchising to function properly, franchisors must be allowed to
control the products served to their customers.94
87
Richard E. Caves & William F. Murphy, Franchising: Firms, Markets, and Intangible Assets, 42 S. ECON.
J. 577 (1976).
88
BLAIR & LAFONTAINE, supra note 1, at 119.
89
Id.
90
Id.
91
JOHN F. LOVE, MCDONALDS: BEHIND THE ARCHES 68, 76 (1986).
92
BLAIR & LAFONTAINE, supra note 1, at 130.
93
LOVE, supra note 91, at 85.
94
BLAIR & LAFONTAINE, supra note 1, at 126-127.
26
However, as the McDonald s experience makes clear, merely specifying product
standards and requiring franchisees to purchase such products from approved vendors will not
eliminate some franchisees individual incentive to deviate from proscribed behavior. Product
specifications must routinely be monitored, through audits, mystery shopper programs and the
like, and sanctions issued for noncompliance.95 As illustrated by a detailed account of the
business practices of five U.S. franchise systems, franchisors typically respond to the use of
substandard or unapproved products with a proportional response.96 Noncompliance on
generic items, such as the stir sticks and sugar packets offered by a donut franchisee, may be
ignored. As one Pizza Hut executive stated, you don t want to burn your goodwill bothering
franchisees with little things. There are too many big issues that we have to deal with like
convincing them to install new ovens to get caught up in the little ones. 97 When faced with
more important deviations, however, franchisors will escalate their response, from engaging in
coaching , issuing defaults, suggesting that the franchisee leave the system, and, ultimately,
terminating the franchise.98
B.
The Price of Approved Products
1.
Beating the Street Every Day
Even when franchisees agree to buy specified products from the franchisor or its
approved vendor, they will often complain that the prices they are charged are too high. While
the franchisor generally can offer good value to the system, franchisors can rarely offer the
lowest price on every product every day. Consequently, after they have gained some
experience in the business, franchisees may discover that some inputs, particularly less critical
products for which the franchise system has lower purchasing volumes, can sometimes or even
always be purchased from someone other than the franchisor at a lower price. For example,
large scale retailers as well as retailers with a business model based on big lots, overstocks and
discount purchases such as Costco and Sam s Club, may offer limited time blue light specials
which may be lower than comparable product delivered by the franchisor every day.
While the items offered by such retailers may not always be in stock or be available
system-wide, and these retailers generally do not include the cost of delivery of the product to
franchisees (which can be a significant portion of the delivered cost of a product), their
existence can create resentment among individual franchisees. Franchisees may come to
believe that they are being overcharged, while failing to appreciate that by refusing to purchase
all of the specified products through the approved supplier and cherry picking only those
products that they want to purchase, the franchisee is decreasing the franchise system s
purchasing power, increasing its distribution costs, and driving higher prices for the remaining
products that the franchisee desires. In order to combat this problem, many franchisors affix
95
Id. at 128.
96
JEFFREY L. BRADACH, FRANCHISE ORGANIZATIONS (1998).
97
Id. at 102.
98
For example, if a McDonald s franchisee knowingly sell[s] food or beverage products other than those
designated by McDonald s or which fail to conform to McDonald s specifications for those products, McDonald s at its
election, may terminate the franchise. 2006 Franchise Agreement, McDonald s USA, LLC ¶ 18(j).
27
their trademark to products for which reasonable substitutes may be available, thereby
transforming generic products into products unique to the system.99
C.
Beating the Street Everywhere: Urban vs. Rural Costs of Delivery
While some retail price variance may occur by region, most franchise systems that
aspire to becoming a nationwide brand must provide products to their customers at the same or
a relatively similar price regardless of the franchised location. In reality, however, the cost of
delivering products to the franchisee may differ dramatically by geographic region and the
franchisee s locations within that region. Consequently, when sourcing products and services,
some franchisees must essentially cross subsidize the delivered cost of products purchased by
other franchisees within the system in order to create a uniform product price. The degree to
which each franchisee s product pricing is subsidized or mitigated will depend on the nature of
the product, the location of the supplier, the distribution costs for the product within each
geographic region, and the location of the franchisee within that region.
Two simple examples illustrate the problem. Consider the country mouse franchisee
with a restaurant in Idaho. His restaurant is located near the source of production of one of the
constituent products on the menu, the Idaho potatoes that are used to make French fries; yet,
the Idaho franchisee will typically pay the same price for the delivered product, French fries, as
the franchisee in downtown Manhattan. In essence, the Idaho franchisee is subsidizing the
production cost of French fries for his urban counterpart. Conversely, consider the city mouse
franchisee in Manhattan. His high density urban location has far lower distribution costs than
his fellow rural franchisees because his distributor has far more deliveries over less mileage.
The urban franchisee is subsidizing the delivery costs of his rural counterpart.
Of course, whether the ultimate delivered cost of any given product will be subsidized by
any given franchisee will vary by product, the source of its production, the cost of inbound
freight from that facility to the distributor, the cost of distribution, and the velocity of the product
(i.e., the sales volume) within each distribution area. Consequently, determining whether the
delivered cost of a given product is actually being subsidized or mitigated by any given
franchisee is more complex than the examples provided above. Moreover, delivered cost
pricing variances will vary from product to product, meaning that the overall cost subsidization or
mitigation incurred by any given franchisee on the panoply of products offered by the franchise
system may well balance out. However, for the Arkansas based chicken QSR franchisee
paying the same cost for chicken as his counterpart in Philadelphia, this knowledge may provide
scant comfort.
D.
Franchisor Remuneration from Sourcing Products and Services
Many franchisees may believe that the initial franchise fee and ongoing royalty they pay
to the franchisor is, or should be, the extent of the franchisor s compensation. While the vast
majority of franchise systems do charge an initial franchise fee100 and receive a royalty on
99
See, e.g., 2006 Franchise Agreement, McDonald s USA, LLC ¶ 12(i) (requiring franchisees to use only
containers, cartons, bags, napkins, other paper goods and packaging bearing the approved trademarks . . . .)
(emphasis added).
100
BLAIR & LAFONTAINE, supra note 1, at 56-61 ( Very few franchisors, only 9 out of 1,125 [surveyed], charge
no such fee. ).
28
sales,101 in reality, most major franchise systems have complex business models that go well
beyond these two forms of revenue. Instead, typical franchise models involve a combination of
corporate owned retail locations, rental income from retail sites, and remuneration from selling
supplies and services to the franchisees.
In the QSR space, for example, based on disclosures contained within their respective
Franchise Disclosure Documents, franchisors with corporate owned units include Domino s,
Jack in the Box, Sonic, Chipotle, Chick-Fil-A, Pizza Pizza, Wendy s, Arby s, McDonald s and the
various retail outlets associated with Yum Brands. Franchisors receiving rent from franchisee
retail locations include Tim Horton s, Jack in the Box, Chick-Fil-A, Wendy s, IHOP and
McDonald s. Franchisors receiving income from the supply chain include Domino s, Chick-Fil-A,
Pizza Pizza, Wendy s, Quiznos and IHOP. Finally, some franchisors receive income through
partial vertical integration (i.e., ownership) of the supply chain, such as Papa John s and Tim
Horton s. While financial conventions make it difficult to gain complete visibility into the
economics of these arrangements, it is apparent that these additional sources of income can be
equal or greater than the income the franchisor receives from the initial franchise fee and
continuing royalties. For example, McDonald s charges a sliding percentage rent based on
sales, which averages about 12% for a typical $1.1M restaurant.102
Tim Horton s provides a good example of the way in which a franchisor combines
sources of income to receive an aggregate return on its investment. According to its 2006
Prospectus, 96.7% of Tim Horton s locations are franchisee owned. Like most franchisors, Tim
Horton s receives an initial franchise fee and a continuing royalty on franchisee sales. However,
Tim Horton s also receives substantial revenues from sales of food and equipment to its
franchisees. Tim Horton s also charges sublease rent on 81% of its franchised sites, resulting in
rental revenue of between 8.5% and 10% of gross franchise revenue. The result is an overall
return on investment for Tim Horton s that is thought to be one of the best in the QSR sector.
The form and manner in which a franchisor receives remuneration from the supply chain
is particularly varied. For example, franchisors may receive annual payments from suppliers
and distributors based on the number of retail locations served. Franchisors may also receive
upfront payments from participants in the supply chain. Often referred to as an exclusivity fee
when received from a manufacturer or vendor or as a sourcing fee when received from a
distributor, exclusivity fees can be a substantial inducement received by a franchisor in return
for providing a long term commitment to purchase from a specific vendor.
During the course of a franchisor s relationship with a supplier, the franchisor may also
receive marketing fees, often from major consumer brands such as Coca-Cola, PepsiCo and
salty snack providers such as Frito-Lay. Such marketing fees are intended to highlight the
vendor s product line at the franchise retail location, but they also have the effect of providing a
significant source of revenue for advertising to drive traffic to retail locations. Franchisors may
also receive payments from vendors and manufacturers based on the volume of sales of the
vendor s products. Referred to by vendors and franchisors as rebates and derisively by some
franchisees as kickbacks, these escalating payments based on increased sales can be a
significant additional revenue stream for a franchise system. For example, in its March 2002
101
As of 2001, 92% of franchisors received on going sales royalties. BLAIR & LAFONTAINE, supra note 1, at
102
2006 Uniform Franchise Offering Circular, Item 6.
68.
29
UFOC, Wendy s reported receiving rebates of between 1% and 15% of the value of goods
purchased by its franchisees. Similarly, in its April 2006 UFOC, Subway disclosed vendor
rebates of between 2% to 37% of sales dollars to be used in the franchisor s sole discretion for
the benefit of its franchisees. Finally, franchisors that directly insert themselves into the supply
chain and take title to the supplies being sold receive a profit margin on the products they sell.
For example, Domino s,103 and Quiznos104 report revenues from such a buy-sell margin.
More than other sources of remuneration, the revenues a franchisor receives from the
supply chain can become a strong point of contention with franchisees. Franchisees have
challenged franchisor remuneration from the supply chain on multiple fronts. Franchisees have
asserted that requiring them to purchase supplies from the franchisor amounts to unlawful tying
of the purchase of the franchise to the purchase of supplies, in violation of the antitrust laws.105
Franchisees have also claimed that the franchise agreement does not require them to purchase
a particular product from a franchisor s approved supplier.106 Franchisees have even asserted
that profits derived from sourcing products and services amount to federal racketeering.107
In response to such challenges, some franchisors have fought vigorously to enforce their
contractual right to remuneration from the franchise supply chain, while other franchisors have
sought to take the issue off the table. For example, Domino s Pizza has agreed to share 50% of
its pre-tax food distribution profits with its franchisees in exchange for the franchisees
commitment to purchase all of their food from Domino s for 10 years.108 Similarly, Dairy Queen
agreed to specific contributions to its advertising fund from the revenue derived from the sale of
supplies to its franchisees.109 Most fundamentally, some franchisors, such as Subway, have
transferred ownership of the franchise supply chain to cooperatives owned by the franchisees
themselves.
VI.
DISCLOSING AND ADDRESSING SOURCING RESTRICTIONS IN THE FRANCHISE
AGREEMENT: BEST PRACTICES
One of Queen City s legacies is to bifurcate the analysis of franchisor sourcing
restrictions into pre-contract versus post-contract perspectives. Since Queen City, courts
103
Domino s Pizza LLC 2006 Uniform Franchise Offering Circular, Item 8.
104
QFA Royalties LLC 2008 Franchise Disclosure Document, Item 8.
105
See, e.g., Queen City Pizza, Inc. v. Domino s Pizza, Inc., 124 F.3d 430 (3d Cir. 1997); Little Caesar
Enterprises, Inc. v. Smith, 34 F. Supp. 2d 459 (E.D. Mich. 1998).
106
See, e.g., Bores et al. v. Domino s Pizza, LLC, 530 F.3d 671 (8th Cir. 2008).
107
Westerfield et al. v. The Quizno's Franchise Company, LLC et al., Case No. 06-C-1210 (E.D. Wisc. Nov.
5, 2007) (unpublished).
108
See Domino s Pizza LLC and Subsidiaries, Notes to Consolidated Financial Statements, Mar. 3, 2006
( The Company enters into profit-sharing arrangements with franchise and Company-owned stores that purchase all
of their food from Company-owned distribution centers. These profit-sharing arrangements generally provide
participating stores with 50% of their regional distribution center s pre-tax profit based upon each store s purchases
from the distribution center. ).
109
This agreement arose following a ruling in Collins v. Int l Dairy Queen, 929 F. Supp. 875 (M.D. Ga. 1976),
in which the court denied International Dairy Queen s ( IDQ ) motion for summary judgment on the franchisees claim
that IDQ illegally tied the sale of food products and supplies to its franchises to its sale of franchise agreements.
30
generally have concluded that franchisors can avoid antitrust liability by making complete, precontract disclosure of supply-related arrangements.110 As a result, plaintiffs after Queen City
have sought to win cases by challenging the quality of the franchisor s pre-contract disclosures
and taking advantage of contract ambiguities or outright omissions. Their aim is to show that
the franchisor acted opportunistically based on incomplete information shared during the precontract stage and failed to reasonably inform franchisees about plans to impose and profit from
the specific sourcing controls that the franchisor later wishes to enforce.
Nothing suggests that franchisors cannot, or should not, address legal risks by drafting
pre-sale disclosures and franchise agreement provisions in broadly-worded, conditionallycouched language that informs the franchisee in the most inclusive of terms that the franchisor
reserves the right (e.g., may) at any point during the franchise term, in the franchisor s sole
discretion (to emphasize its dominion over the subject), impose sourcing restrictions involving
every article or service that may at any time make up the franchisee s operations and, in doing
so, may derive revenue from the arrangement.111 As long as the franchisor further discloses
that the magnitude of future sourcing restrictions may affect up to 100% of a franchisee s
ongoing purchases, current law appears to foreclose the franchisee from later complaining
under any legal theory antitrust, breach of contract, fraud, consumer protection statutes, or
comparable allegations - that it was unfairly locked into purchasing unwanted tied goods even
when the sourcing restriction enables the franchisor to extract supra-competitive prices.112
As long as the franchisor s disclosures and supplier-related contract provisions are clear
and complete, they should not be invalid because the language chosen is sweeping and general
about future action that might or might not ever be taken. Indeed, generalized disclosures about
the franchisor s supplier policies, potential to derive revenue from franchisee-supplier
transactions, right to modify suppliers and supplier policies at any time without notice, and
related topics seems to be the safest approach for reducing legal risks in this area.113
110
Janet L. McDavid & Richard M. Steuer, Symposium: The Law Of Vertical Restraints In Franchise Cases
And Summary Adjudication: The Revival Of Franchise Antitrust Claims , 67 ANTITRUST L.J. 209 (1999).
111
By pre-sale disclosure, we refer to the information contained in the franchisor s franchise disclosure
document which applicable law requires franchisors to give to every prospective franchisee before the franchisee
commits to buy a franchise (unless the transaction is exempt from both federal and any applicable state franchise
sales laws). Section III(A)(1)(b) of this paper explains the scope of mandatory pre-sale disclosures about sourcing
restrictions. As part of the pre-sale disclosure process, the franchisor must provide a copy of all franchise contracts
to the prospective franchisee. Once informed about contractual rights and duties vis-à-vis purchasing arrangements,
current law is relatively intolerant to complaints by franchisees later on during the lifespan of the franchise relationship
about franchisor conduct within the scope of contractually reserved rights.
112
See Warren S. Grimes, Perspectives on Franchising: When do Franchisors have Market Power?
Antitrust Remedies for Franchisor Opportunism, 65 ANTITRUST L.J. 105, n.82 (1996) ( Franchisees are, of course, not
helpless.
[F]ranchisees are protected to some degree by disclosure regulations and by their ability to negotiate
contractual protection.
Precontract opportunism may give rise to legal remedies, as, for example, when the
franchisor is guilty of fraud or misrepresentation or otherwise violates state or federal disclosure protections
Antitrust remedies for these abuses are unlikely. )
113
See Hillman, supra note 66. The author offers this example of a highly generalized disclosure informing
franchisees pre-contract that it may change its supplier policies post-contract: Franchisor reserves the right in its
sole discretion to modify this policy, including without limitation modifying the number and identity of authorized
suppliers of the Products. While Franchisor has not determined at present to modify this policy, franchisee should
expect that it may do so, and that such a modification may increase franchisee's costs of obtaining one or more
Products necessary to the operation of the franchise. Id. at 46.
31
All things considered, pre-sale disclosure and careful contract drafting seem an
extraordinarily simple way to snuff out legal contests over sourcing controls. The advice has not
been lost on franchisors. Franchise agreements today routinely reserve to franchisors broad
reservations of rights to impose, expand, modify, and profit from future sourcing controls even
when supplier restrictions do not exist at the relationship s inception or materially change with
time during its term.114 What is critical is that the franchisor s disclosures be objectively
informative, i.e., be sufficient to impart enough information to make franchisees reasonable
aware of the scope and implications of the franchisor s authority.115
It is fair to say that the real bone of contention over sourcing controls today is not so
much that franchisors regulate purchasing arrangements or derive revenue from franchiseesupplier transactions, but that franchisors do not guaranty their franchisees competitive pricing
of supplies.116 After all, franchisee opposition to sourcing controls typically surfaces only after
they learn they are getting a bad deal.117
So what would franchisees have to say about best practices when it comes to
addressing sourcing restrictions in the franchisor s franchise agreement? An interesting
resource is the Franchisee Bill of Rights published by the watchdog American Association of
Franchisees and Dealers (AAFD). The AAFD s Franchisee Bill of Rights reveals that sourcing
114
See, e.g., SubSolutions, Inc. v. Doctor's Assocs., 436 F. Supp. 2d 348 (D. Conn. 2006). After more than
7 years of litigation over the franchisor s designation of an exclusive POS supplier, the federal district court found the
franchisor s pre-sale disclosures were adequate to put a reasonably prudent franchisee on notice of the franchisor s
right to change its POS specifications and supplier. Further it is an undisputed fact that in franchise agreements DAI
reserved the right to change its product requirements and approved vendors and specified that it could in its
discretion require its franchisees to purchase products from particular vendors. Thus, any prospective franchisee
knew that DAI might require it to purchase some essential item from an exclusive vendor. Id. at 355 (citing Queen
City Pizza, Inc. v. Domino s Pizza, Inc., 124 F.3d 430 (3d. Cir. 1997)).
115
Jeffrey L. Harrison, An Instrumental Theory of Market Power and Antitrust Policy, 59 SMU L. REV. 1673,
1703 (2006) (suggesting that antitrust policy is shaped more by politics than by economic theories). The article cites
Mumford v. GNC Franchising LLC, 437 F. Supp. 2d 344 (W.D. Penn. 2006) in which the court rejected the
franchisees antitrust and common law claims challenging GNC s refusal to approve third party suppliers thereby
forcing franchisees to buy their supplies from GNC. Plaintiffs argued that GNC had not provided complete
information pre-contract about these purchasing restrictions, but the court disagreed. It noted that GNC's franchise
agreement adequately disclosed that franchisees would have to purchase inventory from the company, its affiliates,
or approved suppliers in certain quantities and with other enumerated restrictions, and that GNC reserved the right to
modify the inventory plan in the future. GNC s reservation of rights was expressed in generalized terms: f]ranchisor
reserves the right to modify the General Nutrition Center Inventory Plan, or Plan-O-Grams, by providing reasonable
advance notice of such changes to Franchisee. Id. At 356-57. The decision seems to reject the premise that
adequate pre-contract disclosure requires a franchisor to disclose with specificity the magnitude of future changes or
future costs at the pre-contract stage.
116
Anecdotally, at least, some franchisees sign franchise agreements based on an emotional connection to
the brand and the lure of independent business ownership without carefully reading the disclosure document or
contract or evaluating the experiences of existing franchisees. See Karen B. Satterlee & Kerry L. Bundy, The New
Franchise Rule: You Made Me Do It : Reliance in Franchise Fraud Cases, 26 FRANCHISE L.J. 191 (2007) (reviewing
cases dismissing franchisee claims of misrepresentations based on proof that the franchisee had not read the
disclosure document or franchise agreement before investing in the franchise opportunity.). See also BLAIR &
LAFONTAINE, supra note 1, at 160. The economist authors note that some prospects do not even talk to other
franchisees before making their own commitment, and recommend that franchisees take a more analytical approach
in comparing franchise choices.
117
BLAIR & LAFONTAINE, supra note 1, at 164. ( Basically, recent franchisee [tie-in] allegations boil down to
the complaint that they are being overcharged for requisite ingredients and supplies. This overcharge must be the
underlying source of the franchisees complaint for otherwise they would suffer no injury. ).
32
controls per se are not the real focus of franchisee concern, the lack of competitive sourcing is.
Standard 9.3 of the AAFD s fair standards of behavior, which are designed to level the playing
field between the disparate economic interests of franchisors and franchisees, recognize that
franchisors have a legitimate right to designate suppliers and derive revenue from franchiseesupplier transactions.118 In return, to balance competing interests, Standard 9.3 proposes that
franchisees receive competitive pricing. The AAFD Standard does not expect franchisors to
guarantee competitive pricing or necessarily to address the subject of competitive pricing in the
franchise agreement, but it does expect franchisors to consider the franchisee s reasonable
objective (no different than the franchisor s own) to achieve a competitive return from the
franchise investment and not be exploited by the franchisor s contractual power over the
franchise relationship.
The AAFD s proffered solution to sourcing controls focuses on the proper way to allocate
future, unknown business risks that are neither predictable nor even certain, but over the long
term are inevitable, such as price fluctuations, regulatory changes, competitive changes and
even political changes. All businesses, franchise and non-franchise alike, face these same risks
and confront the same limitations when it comes to predicting and preparing for the future.
Standard 9.3 aspires to balance the economic interests of franchisors and franchisees by
seeking a commitment from the franchisor to maintain a franchisee s competitive pricing
regardless of whatever adjustments the franchisor may make to purchasing arrangements and
sourcing controls as the franchisor leads the franchise system through the uncharted black hole
called the future.
Some economists believe that a more efficient approach to protecting franchisees from
exploitative sourcing controls is more vigorous competition in the sale of franchise licenses.119
If one franchise contract subjects a franchise to a higher risk of exploitation than another
contract, this should be factored into the franchisee s evaluation of profit potential for the two
systems and thus into the final decision as to which franchise contract best suits him. 120
In recommending best practices for drafting and disclosing contract provisions pertaining
to sourcing restrictions, franchisees should give more credit to the multiple benefits of
comprehensive sourcing controls recounted in this paper. A nascent franchise system may be
too small for it to be economical for the franchisor to regulate supplier relationships beyond
approving local sources identified by individual franchisees. However, unless new franchise
chains are forward-thinking and reserve the right to regulate supplier relationships as
comprehensively as the largest franchise systems with well-integrated supply chain
management systems, they may encounter legal challenges if and when they later seek to
change supply arrangements post-contract. Consequently, the best practice for franchisors to
follow is to address supplier topics as if anything may be possible, but recognize that
118
American Association of Franchisees and Dealers, Franchisee Bill of Rights (July 27, 2009),
http://www.aafd.org/images/logo/Standards.pdf. Standard 9.3 entitled Right to Reasonable Profit/Pricing reads:
Where a franchisor designates the source of supply for any products or services and the franchisor or an affiliate
receives and discloses an economic benefit on the sale of such products and services, the franchisor is entitled to a
reasonable profit on the sale of such products and the franchisee is entitled to a competitive price which enables the
franchisee to achieve a reasonable profit margin.
119
BLAIR & LAFONTAINE, supra note 1, at 164-65.
120
Id. at 167 n.188.
33
prospective franchisees may view free-wheeling contract clauses with some degree of
suspicion, if not hostility, in evaluating competing franchise opportunities.
VII.
PROCUREMENT AND VENDOR AGREEMENTS: BEST PRACTICES
A.
An Overview of Procurement
Traditionally, the main activities of a purchasing manager were to beat up potential
suppliers on price and then buy products from the lowest cost supplier that could be found. 121
Today, purchasing is viewed as part of a broader function called procurement. The
procurement function is broken down into four categories: consumption management, vendor
selection, contract negotiation and contract management.
Effective procurement begins with understanding what kinds of products are needed,
from whom and at what prices. The products needed include direct or strategic materials
necessary for the products that the franchise sells and indirect or MRO (maintenance, repair
and operations) products that the franchisees consume as part of daily operations. Expected
levels of consumption for each of these types of products must be set and compared with actual
levels of consumption on a regular basis.
Once there is an understanding of the current purchasing situation and an appreciation
of what a company needs to support its business plan and operating model, a search can be
made for suppliers who have both the products and service capabilities needed. 122 Typically, a
franchisor seeks to narrow the number of suppliers with whom it does business in order to
leverage its buying power to obtain a better price in return for higher purchasing volume, while
maintaining redundant supplier capacity for critical supplies necessary for franchise operations.
Once suppliers are identified, contracts are negotiated with individual suppliers on the
franchisor s preferred vendor list. The simplest negotiations tend to be for MRO products where
suppliers are selected on the basis of lowest delivered price. The most complex negotiations
are for mission critical supplies that must meet the franchisor s specifications or for which high
levels of service or technical support are needed.
Once contracts are in place, the franchisor must measure vendor performance against
the contracts. Specifically, the franchisor must trace the performance of its suppliers and hold
them accountable for the service levels they agreed to provide. If the supplier fails to meet its
contractual requirements, the franchisor must make the supplier aware of its shortcomings and
ensure they are corrected.
121
HUGOS, supra note 10, at 64.
122
Id. at 68.
34
B.
The Nuts and Bolts of the Vendor Agreement
1.
Why is a Vendor Agreement Desirable?123
Some franchise distribution systems, including those of significant size, may employ little
or no documentation with suppliers. Purchases may be made based on a telephone call or an
exchange of email. Suppliers, interested in doing business with a purchaser for multiple
franchise or corporate owned locations, may view a signed agreement as a potential
impediment to a lucrative selling relationship. Franchisors may view themselves as providing
only one thing to the vendor in return for its supplies, viz., money, and may view informal vendor
agreements as providing the franchise system with more flexibility in purchasing. While these
viewpoints may be understandable, from the perspective of the franchisor such informal supply
arrangements are almost certainly mistaken, particularly if the supplies go to the heart of the
products and services provided to the franchisor s retail customers.
The fundamental problem with informal supply arrangements is that the franchisor
cannot ensure a certain and constant supply of the products and supplies needed by the
franchise system on terms that are known and enforceable. Additionally, from a practical
standpoint, a uniform, written vendor agreement with suppliers vastly simplifies administration of
what can otherwise be one of the most complicated and time consuming tasks undertaken by a
franchise system. Depending on the size and nature of the franchise concept, a franchisor may
have hundreds of suppliers for products as diverse as uniforms, linens, cleaning supplies,
toiletries, food, paper, equipment, computer hardware and software and signage. Ensuring a
constant supply of goods made to the franchisor s specifications, accounting for these
arrangements and their terms, and tracing the performance of suppliers to determine whether
they are performing as required, can be nearly impossible unless contract terms are clearly
spelled out, preferably in a uniform form of vendor agreement.
2.
Contractual Structure: Separate Master Agreement and Purchase
Orders
While most franchisors would likely agree that a written vendor agreement is necessary,,
many might naturally balk at the complexity and cost of creating a rigorous agreement with
every vendor, particularly those involving smaller transactions for readily available items. In
contrast, the franchisor s attorney may be hesitant to employ a standard purchase order,
especially if the product is critical to brand integrity, or, as is often the case, it will be branded
with the franchisor s trademark or will be manufactured according to the franchisor s proprietary
specifications.
In many cases, a good solution is to employ a standard master vendor agreement
negotiated at the outset of the relationship, coupled with a purchase order for each transaction
during the course of the relationship. The master vendor agreement sets forth those terms
applicable to every purchase, including the level of commitment, the ownership of the product
and marks, confidentiality, warranties and representations, and product reporting, recall and
indemnification. The purchase agreement incorporates the master agreement by reference and
adds those additional terms that may vary by transaction, including price, freight rates, order
lead time and distribution centers to be supplied.
123
See generally FOLEY & LARDNER, PRODUCT DISTRIBUTION LAW GUIDE § 2.01 (2009) (providing a good
overview of this topic from the perspective of both the buyer and the seller).
35
Separating the master vendor agreement from the purchase order also allows a
franchise system to easily set up multiple supplier relationships for the same product and within
the same region, allowing adequacy of supply and competition amongst vendors. Such
redundant relationships are particularly important for brand critical supplies which may be
especially vulnerable to supply disruption, such as foods subject to contamination or product
recall. By engaging multiple vendors with separate purchase orders for each transaction, the
franchisor can quickly and seamlessly shift the supply to an alternate vendor, ensuring the
franchisor s ability to provide its franchisees with a system critical input.
3.
Designation as an Approved Vendor
Item 8 of the amended Franchise Rule requires franchisors to disclose the franchisee s
obligations to purchase or lease goods, services, supplies, fixtures, equipment, inventory,
computer hardware and software, real estate, or comparable items related to establishing or
operating the franchised business from approved vendors.124 To the extent the franchisor
requires purchases from approved vendors, the vendor agreement should mirror this
requirement by designating the supplier as an approved vendor authorized to sell only those
products specifically requested by the vendor and subject to the franchisor s specifications.125
When coupled with a franchise agreement requiring purchases from approved vendors,
including the approved vendor language within the vendor agreement allows for better
franchise compliance, as the franchisor can easily establish whether a franchisee has
purchased a product from an approved vendor and issue appropriate warnings or defaults to
franchisees purchasing and selling unapproved product. Second, as stated above, establishing
a stable of approved vendors familiar with the franchisor s product specifications and with the
capacity to meet the franchisor s requirements for the product in question helps the franchisor to
avoid product shortages should another approved vendor prove unable to deliver the product
needed, either temporarily or long term. Third, including the approved vendor nomenclature
within the vendor agreement allows the franchisor to more easily comply with its Item 8
obligation to identify the goods or services required to be purchased.126
4.
Ownership of Product and Intellectual Property
Many franchise concepts assert ownership of the products and services they provide,
whether the 11 herbs and spices comprising Kentucky Fried Chicken, to the methods employed
to pamper guests of Starwood owned luxury hotels.127 As part of the vendor agreement, the
124
16 CFR § 436.5(h) ( Item 8: Restrictions on Sources of Products and Services ).
125
At the same time, the vendor agreement should clearly state, notwithstanding the approved vendor
designation, that the vendor agreement is not an exclusive dealings contract and that the franchisor may engage
other vendors or service providers to provide the same or similar products.
126
16 CFR § 436.5(h)(1).
127
See, e.g., Court Enjoins Hilton, Ross Klein and Amar Lalvini in connection with Litigation filed by
Starwood, N.Y. Times, Apr. 24, 2009. In this case, Judge Stephen C. Robinson, United States District Judge for the
Southern District of New York, entered a stipulated preliminary injunction in connection with litigation filed by
Starwood against Hilton Hotels Corporation and former Starwood executives Ross Klein and Amar Lalvani. Starwood
alleged that Klein and Lalvani, aided and abetted by Hilton, stole massive amounts of proprietary and highly
confidential Starwood information which was used to expedite Hilton s entry into the lifestyle hotel market, reposition
its luxury brands and substantially reduce its costs and risks of doing so. The preliminary injunction barred the
defendants from using, directly or indirectly, any documents or information derived from Starwood).
36
supplier should acknowledge that many of the products to be provided are proprietary and
unique to the franchisor s brand and may not be sold, distributed or supplied to any party other
than the franchisor absent written consent in advance. Such a provision is obviously important
to safeguard the franchisor s property. Such a prohibition also reduces potential liability to
unauthorized third party purchasers, who may use the product incorrectly or after the use by
date. While one might anticipate supplier resistance to such a limitation on sales, particularly
when the supplier has a dominant market position, such prohibitions are relatively common.128
Suppliers may also be involved in the creation of new products for the franchise system.
In addition to new products rolled out by the franchisor, such products may also include
products developed by the supplier as new sources of raw material become available, or
resulting from new methods of manufacturer. In either case, the ownership of the new product
may be contested if it is not addressed within the vendor agreement.129 Therefore, the vendor
agreement should specify that new products designed and produced by the vendor at the
direction or on behalf of the franchisor belong exclusively to the franchisor. The vendor should
also affirmatively agree to cooperate with the franchisor in obtaining intellectual property
protection for any intangible or tangible work product produced.
Finally, it is recommended that products manufactured by the vendor employ the
franchisor s trademark and trade dress in product packaging and labeling. While exceptions
obviously exist for products that are off the shelf, branding the property has a number of
positive effects. For example, the franchisor can more easily determine whether the vendor is
supplying product to third parties in violation of the vendor agreement. Branding also increases
franchisee compliance with purchasing obligations, as the product is more likely to be deemed
unique to the franchisor and of greater value, and because unapproved purchases may be more
easily spotted during inspections by the franchisor. Of course, if the franchisor authorizes the
vendor to use the franchisor s trademark, the vendor agreement should also include a license
limiting the vendor s use of the mark solely in connection with the products it is producing, and
the vendor s agreement to immediately notify the franchisor of any infringement or challenge to
the mark of which the vendor becomes aware.
5.
Confidentiality
The manufacturer of supplies is entrusted with one of the franchise system s most
valuable assets: the brand s product specifications. Often, a manufacturer is also directly or
indirectly privy to other highly proprietary aspects of the franchisor s business plan.
Manufacturers source materials for new product testing and enter into purchase agreements for
future marketing events and limited time offers. Depending on the nature of the franchise
supply chain, manufacturers (and distributors) may also be aware of product profit margins and
sales volumes by product, either regionally or nationally. Should the franchisor employ master
vendor agreements and enter into long term relationships with its suppliers, the likelihood that
the vendor will become privy to confidential information becomes even greater.130 Accordingly,
as part of the vendor agreement, the franchisor and the supplier should enter into an agreement
in which the supplier agrees to maintain all confidential and proprietary information of the
franchisor. Franchisor information typically subject to such an agreement may include lists of
128
FOLEY & LARDNER, supra note 123, at 2116.
129
Id. at 2117.
130
Id. § 2.24A.
37
vendors, products, recipes, formulas, specifications, food preparation procedures, devices,
techniques, plans, financial information, forecasts, advertising and pricing.
6.
Level of Commitment: Requirements Contracts
If, as discussed above, the franchisor opts to employ a long-term master vendor
agreement with multiple purchase orders, it is generally optimal to structure such agreements as
requirements contracts.
A requirements contract, within the meaning of the Uniform
Commercial Code,131 is an agreement in which the supplier is required to sell and the franchisor
to purchase all of the franchisor s requirements for a particular product.132 While vendors will
often push franchisors for specific volume commitments (typically in return for promised
reductions in unit prices), it is recommended that no guarantee of purchase volume be provided.
Instead, it is preferable to provide the vendor with a forecast based on historical sales, making
clear that the franchisor is making no representation or warranty regarding the amount of
products that will be purchased by the franchisor. Further, the vendor should specifically
acknowledge to the franchisor that future volumes can vary substantially depending on market
conditions, product eliminations, promotional activities, new product introductions and other
factors that cannot be foreseen. A franchisor can further circumscribe its commitment to the
supplier by limiting its requirements to those of one or more regional distribution centers
assigned to the vendor. The franchisor should also reserve the right to add, delete or reassign
the distribution centers assigned to the vendor, and make clear that the franchisor has no
obligation to make up any volume to the supplier resulting from such changes.
This is not to say that the franchisor may disregard the forecasted volume it provides to
the vendor carte blanche. Under the UCC, such forecasts must be made in good faith, and no
quantity unreasonably disproportionate to any stated estimate or, in the absence of a stated
estimate, to any normal or otherwise comparable prior output or requirements, may be tendered
or demanded. 133 Therefore, the franchisor should attempt to forecast its needs as accurately
as possible and advise the vendor if its anticipated requirements are likely to change.134
7.
Risk of Loss, Pricing and Payment Terms
When a master vendor agreement is employed, the specific price and payment terms for
any given purchase are typically specified in each applicable purchase order. The franchisor
should seek to obtain a price based on F.O.B. destination, rather than F.O.B. shipping point. By
specifying F.O.B. destination, the franchisor shifts the risk of loss to the vendor until the goods
reach the destination specified. Conversely, if the price is quoted as F.O.B. shipping point, the
risk of loss shifts to the franchisor at the point of the place of shipment, i.e., the vendor s facility.
If the franchisor is employing single source distribution, the F.O.B. destination would typically be
the regional distribution warehouse.
131
As franchise supply arrangements typically involve the sale of goods, the Uniform Commercial Code
( UCC ) forms the backdrop for vendor agreements. Article 2 of the UCC governs the sale of goods.
132
See UCC § 2-306(1).
133
Id.
134
FOLEY & LARDNER, supra note 123, at 2116.
38
When purchasing critical supplies with limited manufacturers, the franchisor should seek
to lock in a fixed price for the term of the purchase order, without any additional charges for
taxes or other fees. Consistent with delivery F.O.B. destination, the franchisor should also not
be required to make any payment until a fixed period after delivery, rather than upon the date of
shipment, and the franchisor should seek a credit limit in an amount sufficient to allow the
purchase of all of the products covered by the individual purchase order.
Finally, a franchisor should seek a warranty from the supplier to provide most favored
nation pricing. As generally understood, a most favored nation contractual provision is a
representation or warranty by a vendor that the prices, net of all discounts, for any products
provided by the vendor to the franchisor shall not be greater than those prices currently being
charged to any other customer of the vendor for similar items purchased in substantially equal
amounts. If the vendor reduces its pricing to any other customer for such items during the term
of the vendor agreement, the vendor agrees to also reduce the prices for the products supplied
to the franchisor. Again, in an era of extreme price volatility, such a most favored nation
provision can be extremely helpful in allowing the franchisor to deliver goods and services to its
franchisees at the most competitive price possible.
8.
Warranties and Representations
Any discussion of warranties within a vendor agreement must be placed firmly within the
context of the treatment of warranties within the UCC. The UCC addresses warranties relating
to the quality of goods and warranties relating to title and infringement.
With respect to quality, warranties may be either express or implied.135 Express
warranties arise when the seller describes the goods in words, provides a sample or makes
promises regarding the quality of the goods.136 Simply by supplying goods to the specification
of the franchisor, a vendor will typically be deemed to have made an express warranty that the
goods meet such specifications.137 Unless specifically excluded, the vendor, as a merchant, 138
also makes an implied warranty that the goods sold are merchantable, i.e., that the goods
would pass without objection as being the goods described.139 Finally, an implied warranty of
fitness for a particular purpose arises when the seller knows about the purpose for which the
buyer is purchasing the goods, and the buyer is relying upon the seller s expertise in supplying
the goods.140
135
See generally Patrick J. Maslyn & W. Andrew Scott, Contractual and Business Aspects of Structuring
th
Supplier Agreements, 30 Annual Forum on Franchising, at 12 (discussing in detail the express and implied
warranties applicable to supply contracts).
136
UCC § 2.313(1).
137
Maslyn & Scott, supra note 135.
138
UCC 2-104(1) Merchant means a person who deals in goods of the kind or otherwise by his occupation
holds himself out as having knowledge or skill peculiar to the practices or goods involved in the transaction, or to
whom such knowledge or skill may be attributed by his employment of an agent or broker or other intermediary who
by his occupation holds himself out as having such knowledge or skill.
139
UCC § 2-314(1).
140
UCC § 2-315.
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With respect to title and infringement, under the UCC the seller warrants that he has
good title to the product and may transfer it free of an lien or encumbrance.141 Merchant sellers
also warranty that the goods do not infringe on the property rights of other sellers.142
While the UCC provides buyers broad protection, it is recommended that the vendor
contract specify the warranties the parties intend to provide and receive.143 For example, with
respect to quality, the contract should specify that the vendor will deliver goods that conform to
the buyer s specifications and are free of defects and fit for their intended use. The contract
should also include specific warranties relating the type of goods being purchased. For
example, in the case of a food franchise, the buyer will want warranties that the goods are not
adulterated or misbranded within the meaning of applicable laws such as the Federal Food,
Drug and Cosmetic Act144 and the Poultry and Poultry Products Inspection Act.145
The franchisor should also seek warranties regarding the vendor and its operations. For
example, the vendor should warrant that it is in good standing in all jurisdictions in which it
conducts business, and that it is in compliance with all applicable laws. When the consumer of
the goods is not the direct purchaser of the goods, as is nearly always the case within the
context of the franchise supply chain, the vendor contract should also state that all warranties
survive delivery of the product and run to the ultimate consumer, notwithstanding that the
consumer has no contractual privity with the vendor.
Finally, to remove any doubt raised by the specification of warranties with the vendor
agreement, the supplier should warrant that it is not disclaiming any express or implied warranty
with respect to the goods sold.
9.
Reporting, Product Recall and Indemnification
Having required the vendor to warrant the merchantability of the goods and the vendor s
compliance with all applicable laws, it is helpful to include a provision within the vendor
agreement in which the vendor advises the franchisor should it fail to satisfy its warranties. The
vendor should agree to immediately advise the franchisor of any problems related to the goods
or the facility in which they are manufactured including labeling issues, product contamination,
manufacturing or packaging errors, or any other action or omission that could impact the safety,
efficacy or salability of the goods, along with the corrective actions being taken. The vendor
should also advise the franchisor of regulatory action or inspections involving its facilities or
goods, and the remedial action taken by the vendor in response.
If any of the goods are subject to a product recall or seizure, or if any governmental
agency requests or suggests a product recall, the vendor should agree to comply with the
franchisor s product recall procedures, which should be attached and incorporated into the
vendor agreement by reference. While the nature of the product recall procedures will vary
141
UCC § 2-312(1).
142
UCC § 2-312(3).
143
FOLEY & LARDNER, supra note 123, at 3016.
144
21 U.S.C. § 301 et seq.
145
21 U.S.C. § 451 et seq.
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considerably depending on the nature of the franchise system, all franchisor recall procedures
are designed to protect the health and safety of the franchisor s consumers, ensure franchisor
compliance with all laws, and minimize exposure to liability. In instances in which a recall has
not been mandated by a government agency, such procedures also establish benchmarks for
when the franchisor or its vendors should initiate a product recall, including identification of the
problem, implementation of product retrieval, and termination of the recall.
In the event of a product recall, the vendor should agree to be solely liable and to
indemnify the franchisor for all costs associated with the recall, including (i) notification of
distributors, franchisees and consumers, (ii) freight charges associated with product retrieval,
and (iii) counsel and advisor fees associated with the recall. The vendor should also agree to
replace recalled products free of charge, or, in lieu of replacement, refund the purchase price.
In the event the vendor is unable or unwilling to provide replacement products to the franchisor s
specifications, the franchisor should be allowed to obtain replacement products from other
suppliers, and the vendor should agree to be liable for the additional expense associated with
obtaining the replacement products (i.e., cover damages). Further, in a business arena in which
even a successful product recall can cause lasting damages to the franchisor s brand, the
vendor should agree that neither the vendor nor the franchisor will make statements to the press
or the public without first consulting the other.
Finally, whether or not a product recall is initiated, the franchisor should seek broad
indemnification from the vendor with respect to any liability resulting from the goods being
purchased.146 For example, the vendor should indemnify the franchisor for any damages or loss
resulting from the products being purchased. The vendor should indemnify the franchisor for
any breach of warranty or of the contract, as well as any losses resulting from the willful or
negligent acts of the vendor or its agents. Lastly, the franchisor should seek indemnification
from the vendor for any product liability resulting from the goods sold.
VIII.
CONCLUSION
A company that is supported by a systematic and strategically coordinated supply chain
has significant competitive advantages over its competitors. This truism applies to both
franchise and non-franchise systems alike.
In the franchise context, supply chain performance allows franchisees to depend on the
reliable delivery of inventory, supplies and other materials that are both essential for the
franchisee s operations and uphold brand standards. In order for a franchisor to optimize a
supply chain s efficiency and responsiveness to the needs and requirements of chain
participants including the supply chain s ultimate customer, the franchisee, the franchisor must
capture and integrate a vast amount of knowledge. This knowledge ranges from its own
communication of specifications to chain participants, to managing the raw materials providers,
transporters, warehouses, and intermediate handlers who mix or assemble raw materials, and
to ensuring efficient order management and the timely distribution of finished, mixed or
assembled goods to each individual franchisee. Additionally, the franchisor must have the
expertise to measure the performance of the various supply chain drivers and strategically
forecast and plan not just with respect to future production needs, but also about whether to
enter a new market or exit from an existing market and how best to address competition.
146
See FOLEY & LARDNER, supra note 123, at 3019 (itemizing the losses for which indemnification should be
sought).
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Even if the franchisor outsources supply chain management, the franchisor must still
monitor competitive, financial and other fluctuating variables and adjust supply relationships
appropriately to ensure that its franchisees receive maximum value from the outside supply
chain manager. To accomplish these ends and guaranty that the consumers experience with
the brand remains consistent with the franchisor s uniform operating methods and quality
standards, a franchisor must exert considerable control over the supply chain s constituents.
Information technology today allows companies to capture data and combine and process data
flowing from disparate chain participants into useful reports, and communicate information
inexpensively and rapidly to other companies in the supply chain that depend on the real-time
information to perform their own functions. This includes data such as demand forecasts,
inventory status, production capacities, transportation and delivery schedules, sales promotions,
new product specifications and designs, order processing, customer feedback, competitor
intelligence, and market trends.
The sophistication of a franchise system s supply chain management will likely develop
as the franchise system matures and grows in size. A nascent franchise system s involvement
in supply chain functions may be limited to issuing product specifications and approving third
party suppliers that individual franchisees select in their local markets. A mature franchise
system s supply chain management may be highly integrated and coordinated and extend not
only to designating specifications for all elements of operations, but also to designating all
suppliers or serving as the exclusive supplier to the system.
Existing franchisees likely have their own opinions as to the relative value of sourcing
controls. When sourcing controls yield no economic upside for franchisees, or, even worse,
when franchisees perceive no purpose in sourcing controls other than to guaranty the franchisor
another stream of revenue from the franchise relationship, then sourcing controls can be a
highly divisive issue within a franchise network. Even if supply chain management improves the
efficiency of inventory procurement, it may be difficult for franchisees to see past the profits that
their franchisor is able to reap from by being able to force (contractually speaking) a captive
audience of franchisees to buy all of their requirements from the franchisor s designated
sources, which may be the franchisor or its affiliate. When franchisees perceive that purchasing
controls leave them victims of franchisor opportunism, it is especially hard for franchisees to see
any of the benefits that flow from sourcing controls, which range from maintaining quality control
standards and ensuring on-going product availability, competitive pricing and brand protection,
to saving franchisees time otherwise spent on inventory procurement and curtailing
opportunistic free-riding by other franchisees in the system.
Differences in perceptions about the virtues of sourcing controls may be attributed to the
fact that franchisors and franchisees have divergent economic interests that are nevertheless
highly interdependent. Supply chain issues are so complex that prospective franchisees,
especially less sophisticated ones, may not know how to value a franchise network with a highly
efficient supply chain. As for the legal risks arising from sourcing controls, these appear to be
significantly curtailed through diligent pre-sale disclosures that are consistent with the
franchisor s past and current practices.
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ROCHELLE SPANDORF
Rochelle Spandorf, a Certified Legal Specialist in Franchise and Distribution Law in
California, is a partner with the national law firm of Davis Wright Tremaine LLP in its Los
Angeles office. She has more than 30 years of experience representing franchisors,
manufacturers, licensors, and suppliers in their domestic and international expansion and
strategic development. She works with clients in diverse industries, from start-up concepts to
mature public companies, in helping them structure domestic and international franchise,
licensing, dealer and distribution programs. She helps numerous franchise companies comply
with franchise sales laws by preparing disclosure documents, franchise contracts and financial
performance representations. She counsels manufacturers, suppliers and franchisors on a
broad array of operating issues ranging from contract enforcement to trademark protection,
relationship disputes, antitrust and pricing matters, terminations and transfers, and mergers and
acquisitions. She also advises product manufacturers, suppliers and licensors on possible
alternatives for structuring distribution networks so they are not regulated as franchises. Ms.
Spandorf is nationally ranked by Chambers USA as one of the nation s leading franchise
attorneys. She also has the distinction of being the first woman to chair the American Bar
Association s Forum on Franchising, the nation s leading franchise law association. She has
twice served as chair of the California State Bar Franchise Law Committee and currently serves
on the California State Bar Board of Legal Specialization Committee for Franchise and
Distribution Law. She is a frequent speaker and author on franchise topics for numerous
professional organizations. She graduated from the Washington University School of Law and
Cornell University with distinction.
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CHESLEY K. BUD CULP III
Bud Culp is a partner in the Denver, Colorado law firm of Moye White LLP, where he is a
member of the firm s Franchise and Distribution Practice Group. Bud has extensive experience in
reviewing, structuring and drafting agreements for franchise, licensing and distribution
relationships and in regulatory compliance. Bud is also a skilled litigator who has tried, arbitrated
and mediated franchise disputes involving system compliance, protection of trademarks and trade
secrets, class actions and antitrust issues.
Prior to rejoining Moye White in 2009, Bud was Vice President and Assistant General
Counsel for Quiznos Sub, at which Bud managed all of Quiznos North American litigation and
served as lead counsel for Quiznos Canada Restaurant Corporation.
Bud has a B.A. from the University of Colorado (Phi Beta Kappa, with distinction), and a
J.D. (cum laude) from Harvard Law School.
Phone: 303 292 7958
Fax: 303 292 4510
Email: [email protected]
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